The “Clearing” Broker vs. The “Prime” Broker

We are often questioned on the definition of “prime brokerage.” The various names by which banks and broker-dealers label a collection of products and services (prime services, prime finance, equity financing and services, etc.) hint at the fact that there is little consistency among market participants. The scope of such business units variously includes or excludes execution, clearing, and/or financing of physical securities (equity and fixed income), OTC derivatives, and listed futures and options. Inconsistency makes it difficult for regulators to measure and for managers to benchmark themselves to competitors.

In the article entitled The Future of Prime Brokerage, we suggested that prime brokerage could be defined as the center of both client service and secured funding for a bank or broker-dealer. With stock loan, margin lending, and total return swaps all essentially exchanging equity securities for cash or vice-versa, consolidating the management of these secured funding transactions (along with equity repo, forwards, and high-delta options and option combinations) minimizes risks and optimizes the balance sheet. We also suggested that this concept can be extended beyond the equity asset class into liquid fixed income securities that are financed via comparable instruments (usually repo).

We also argued that prime brokerage can be the consolidation point for client activity across the bank or broker-dealer, thereby facilitating reporting, portfolio-level financing, and consolidated margin. In so doing, prime brokerage provides the single point of post-trade client service for all institutional investors.

Prime brokers generally do the clearing for trades that they accept from executing brokers on behalf of their clients. The scope of the prime brokerage relationship is defined by the set of products that the prime broker can clear. At a minimum,  prime brokers clear cash equity trades themselves (“self-clearing”) rather than relying on a correspondent. Many prime brokers also accept listed equity derivatives, which gives their clients more flexibility and convenience. Some primes (such as NewEdge) emphasize clearing of listed derivatives.

The enactment of the Dodd-Frank legislation in the US has brought focus on the clearing of listed derivatives. The management of listed futures and options clearing within banks and broker-dealers varies, which may affect the product scope of the prime brokerage offering at a bank or broker-dealer:

• Alignment with institutional equities builds on the core knowledge of exchange mechanics and electronic trading in the equities business;
• fragmentation by asset class puts profit and loss from various contracts into the related product area, e.g. revenue from interest rate futures booked into the rates business and from equity index futures into the equities business;
• management as a stand-alone business line (including execution and clearing) due to the unique nature of listed derivatives and their risk and collateral requirements over the life of the contracts;
• alignment with traditional prime brokerage businesses, for management of portfolios using listed derivatives for risk mitigation and serving firms who borrow securities and cash in support of market-making activities.

As banks and broker-dealers seek to optimize their respective balance sheets and capital requirements, just as institutional investors will seek portfolio-level margin and consolidated service and reporting, the distinction between the “prime” broker and the “clearing” broker may vanish. With more products moving to exchanges or central counterparties (CCPs), centralized optimization of the bank or broker-dealer’s funding in the context of CCP requirements and heightened controls over customer collateral is critical.

We advocate the management of clearing activity for all trading products within the prime brokerage or prime “services” operation. The definition of “prime brokerage” then extends to three specific utilities across global markets:

1. Securities finance
2. Client service
3. Clearing

Of these functions, securities finance compliments a sales and trading (execution) business in the related securities, usually equities. Similarly, clearing compliments an execution business in listed derivatives. Among various banks and broker-dealers globally, players may emphasize one or the other, or both lines of business. For example, European banks operating in the US may be significant players in listed derivatives but not in cash equities, favoring a prime brokerage business built on clearing. Smaller broker-dealers may deal in cash equities but not derivatives. With a smaller balance sheet, such broker-dealers may emphasize the client service aspect of prime brokerage and source financing for their customers in the wholesale markets. The largest banks may have the largest scope, serving clients active in cash as well as derivatives, from execution through to clearing and custody.

When should execution as well as clearing, custody, and secured financing be a part of prime brokerage? We would suggest that when financing of an asset is the primary component of setting price (spread) and margin (haircuts), then the execution component of the product is a candidate for integration with prime brokerage in order to apply common practices for secured lending transactions. Incorporation of execution functions may be difficult for prime brokerage businesses built on post-trade margin financing, just as it may be difficult for fixed income repo or equity derivatives trading desks to appreciate the commonalities of their products with margin and securities lending.

If prime brokerage is used as a firm-wide utility and not as part of a product silo, broader linkages to execution services (defined by electronic trading tools, exchange connectivity, and clearing) allow for straight-through-processing and better operating leverage for banks and broker-dealers. By increasing the number of products that a covered by clearing, financing, and reporting, the prime broker will have a more complete value proposition for asset managers and a greater ability to manage collateral and risk exposures.

A final note on the distinction between the clearing “function” and the clearing “platforms” at a bank or broker-dealer. The clearing “function” is performed on behalf of trading clients and may require financing (the lending of cash and/or securities) to facilitate settlement, either of which are a natural fit within prime brokerage. The clearing “platforms” are the technologies on which the clearing is done. The management (maintenance and operations) of the platforms may be performed outside of prime brokerage, such as within the GTS business of Citi, or the TTS business of JP Morgan. In these instances, the platforms may be used by the firm’s own global markets businesses as well as offered to the firm’s other clients, who may be broker-dealers themselves.

What Is Your Value Proposition?

[part of a series on hedge fund sales coverage]

When advising banks and broker-dealers in global markets, we are often surprised to discover that client-facing professionals in sales or product management are unable to clearly differentiate themselves from their competition, even to explain why an institutional investor should transact with them before any other firm.

The solutions to this problem lies in understanding the bank or broker-dealer’s value proposition from the perspective of its client, the institutional investor.

The value proposition of a bank or broker-dealer to institutional investors is a bundle of resources that the investor will pay for. Ideally these resources are unique to the bank or broker-dealer. In order to compete effectively, resources must be differentiated in some way, either by comparative excellence or in unique combinations. Any bank or broker-dealer with an incomplete or merely parity offering may find itself able only to compete on the basis of price. Favorable legal or credit terms may bring additional risk, just as favorable pricing may result in lower profitability. These should be balanced commercially rather than included in the base value proposition.

Examples of such resources include: access to corporate client management, knowledgeable analysts, conferences, access to capital or balance sheet, exclusive distribution channels or stock loan supply, expertise in related asset classes, access to global markets and exchanges, risk analytics, client facing technology, operational ease, and so on. For example, a bank with lending relationships to companies in the energy sector that also trades commodities and provides research and makes markets in energy stocks and options may differentiate itself through a comprehensive and deep understanding of the energy sector. The valuable resources in this example include access to the bank’s corporate clients, access to its research (including insights from the commodities markets), thoughts from the bank’s risk managers on sector risks and their mitigation, and more consistent markets from the bank’s traders resulting from deeper understanding of the sector.

Client profitability should be measured across all products of the bank or broker-dealer, with appropriate costing for resource consumption by the client. A common mistake made by bank or broker-dealer management is failure to look outside of a product silo to construct a broad value proposition. For example, investors may value resources that are “owned” by other geographic regions or product areas of the bank or broker-dealer. Better coordination across product and regional silos can yield additional revenues, as investors increasingly pay for resources indirectly, by consuming seemingly unrelated products or services. Only with the support of the bank or broker-dealer as a whole can new business lines hope to grow, as it is otherwise difficult to compete in mature markets.

Resources are distinct from products, which are the primary collection mechanism for client revenues. Simply offering a product is not necessarily valuable to a client; however, the client may begin trading in a product in order to pay for something the client does value. Increasingly, institutional investors are taking a consolidated view of their banks and broker-dealers as opposed to a segmented view across specific product desks. This is most apparent in equities businesses, where hedge funds measure payments to banks and broker-dealers across cash, derivatives, and financing. For example, prime brokerage (financing) may be a profitable product for banks and broker-dealers; however, prime brokerage on its own is difficult to differentiate, particularly for new or smaller entrants. Prime brokerage balances may be a means of payment for resources consumed elsewhere at the broker, such as research or capital facilitation.

In order to drive profitability, resources must be scarce. If a corporate meeting has limited capacity or an analyst has limited time to speak with clients, competition among clients for access to these resources may result. The practice of resource allocation can be used to manage client behavior and to drive profitability. Access to resources may be given  to profitable clients on a priority basis. At the same time, the bank or broker-dealer may invest resources in promising clients with the ability to pay, or deny resources to clients who are not as profitable as they might be. Denying resources is the hardest action to take, but it can be most effective if communicated with tact and supported with accurate data on profitability.

Finally, value propositions may shift over time, often resulting from change in the strategy or organization of the parent company. For example, prior to the sale of Smith Barney to Morgan Stanley, Citi Global Markets may have emphasized its retail distribution, captive order flow, and stock loan supply as differentiating strengths or resources. Subsequently, the group may need to adjust its value proposition to emphasize the custodial capabilities and global network of Citi on the banking side.