Hedge fund prime brokerage is provided by a prime broker.  While the central service the prime broker provides to a hedge fund is trading services, the prime broker provides many other services to hedge funds as well.

Trading and execution

Generally a hedge fund prime broker will act as a hedge fund’s central broker and will execute most of the hedge fund’s trades.  Many prime brokers have online interfaces and/ or programs which allow a manager to automate many trades.  Additionally, the prime broker will be able to execute trades in large blocks and will also be able to execute trades in illiquid securities for the fund.

Custodial and settlement services

One of the main advantages of having a prime broker is that the broker will act as a custodian of the fund’s assets.  If the hedge fund executes trades through other brokers, the prime broker’s back office will work with the back office of the executing broker-dealer to make sure that the assets are settled and transferred over to the fund’s account at the prime broker.

There are a couple of advantages of having the assets custodialized at one institution: (i) reporting of the fund’s positions is easier when there is one custodian and (ii) the prime broker can use all of the fund’s assets for margin purposes (instead of simply part of the fund’s assets if there are multiple brokers or custodians).

Other Services

In addition to custodial and execution services, the prime broker can provide a whole host of other services including:

Leverage and margin – prime brokers can provide the fund with leverage and margin, depending on the fund’s investment program and circumstances.

Short sales – prime brokers generally have a “short box” of securities which can be borrowed to be sold short.

IPOs – prime brokers will often have access to initial public offerings.  Some hedge funds will choose a prime broker based on the broker’s ability to allocate IPOs to the fund.

Capital introduction – a prime broker may, in certain circumstances, introduce potential investors to the hedge fund.

Reporting – the prime broker can produce period reports which can be sent to the hedge fund administrator or to hedge fund investors.

Soft dollars – the prime broker may be able to provide certain research and other items to the hedge fund manager.  Under revised soft dollar guidance, soft dollars cannot be used for non-research items such as computer equipment or rent for the hedge fund’s management company.

Office space and IT support – some prime brokers (and other broker-dealers) will provide office space and IT support for hedge funds.  Such arrangements are often called by the perjorative term “hedge fund hotels.”

Stress test analysis and other portfolio monitoring

Joint Back Office (JBO) arrangements – these arrangements allow a hedge fund to receive more margin by becoming a broker-dealer.  These arrangements used to be more popular but the margin rules changed to a risk-based model which, for many hedge funds, abrogated the need for many JBO arrangements.

Deciding on a prime broker

The prime broker is definitely a major piece of the hedge fund puzzle.  You should discuss prime brokers with your hedge fund attorney; your attorney will be able to give you some recommendations based on your trading program and other factors.  Please contact us if you have any questions.