The emerging digital asset industry is looking to adopt the prime model to service a new wave of institutional clients. While digital asset prime may not settle on identical solutions provided by traditional prime, it will be rooted in an identical purpose – a master relationship that facilitates access to all relevant products, markets, and service providers.
In our Institutional Digital Asset Survey, we found that institutional investors' interest in digital assets is on the rise. From 2019 to 2020, the portion of US investors with an allocation of digital assets increased from 22% to 27%. Even more encouraging, 44% of traditional hedge funds surveyed expect to have a bitcoin allocation of more than 1% in the next five years.
As institutional interest in the digital asset market grows, so is the demand for more robust financial services. In traditional markets, hedge funds and other money managers outsource functions to prime brokers to maximize credit, improve efficiency, and reduce overhead. Prime brokers provide a suite of services such as execution, custody, securities lending, margin financing, capital introduction, and more. By consolidating these functions into one easy-to-manage relationship, prime brokerage has grown into a $30 billion business.
Now, the emerging digital asset industry is looking to adopt the prime model to service a new wave of institutional clients. To date, multiple businesses provide one or more of the core services provided by a prime broker, but no single player has yet to check all of the boxes. While the digital asset space requires a unique set of tools to service its customers, there are clear benefits to building a more streamlined and integrated product offering. In this piece, we cover the history of prime brokerage, its revenue generating services, and the importance of prime for digital assets.
History of prime brokers
Although the concept of a prime broker has been around since the 1950s, the business was popularized in the 1970s with prime pioneer Furman Selzi. Prior to the development of prime brokerage, money managers had to keep track of their trades across multiple brokers and exchanges, consolidate positions across venues, and calculate performance themselves. Service providers and money managers eventually recognized that it was more efficient for money managers to work with providers with the expertise to offer the infrastructure and technology needed to help them scale rather than building it themselves. Recognizing the lucrative revenue opportunity, bulge bracket firms (large multi-national investment banks) soon entered the market to compete for prime business. Initially, prime brokers provided services related to equities but evolved to include fixed income, futures and derivatives, and foreign exchange over time.ii
The prime services industry underwent significant change in the aftermath of the 2007-2009 global financial crisis, especially due to the widespread loss of funds in response to the bankruptcy of prime broker, Lehman Brothers, as well the challenges faced by firms such as Bear Stearns and Merrill Lynch. Regarding Lehman, clients discovered that the firm had bypassed rehypothecation limits in the US, where prime brokers could only rehypothecate assets up to 140% of their value. Rehypothecation refers to the practice of the broker using assets posted as collateral by clients. The firm may use the collateral to raise cash and fund loans extended to other clients. The firm may also lend out the collateral assets directly to other clients looking to establish a short position in the assets in question.iii
Lehman was able to rehypothecate assets in excess of the US limit by transferring the assets of US clients to its UK entity (Lehman Brothers International Europe, or LBIE). These clients found themselves with little to no recourse as they were considered general (unsecured) creditors in UK insolvency proceedings. As a result, the hedge fund industry put forth new requirements such as greater use of custodians, restrictions on rehypothecation, and the multi-prime model.iv
Clients demanded that prime brokers keep client funds separate from funds of the broker. In response, clients chose third-party custodians to maintain idle funds (i.e. funds not being used as collateral)v and certain prime brokers established new entities solely to serve the custody function for the firm’s clients. For example, JP Morgan combined its global custody offering with the prime brokerage business it inherited in its acquisition of Bear Stearns to set up a competitive prime offeringvi and HSBC launched HSBC Prime Services in 2009, touting transparent and segregated custody and a strong balance sheet.vii Following the financial crisis and Lehman collapse, hedge funds also negotiated restrictions on the level of rehypothecation permitted or prohibited rehypothecation altogether. A consequence was an increase in pricing for prime brokerage services due to new costs associated with custody services and the inability for prime brokers to rehypothecate to the same extent, one of the key reasons that prior to the financial crisis, fees paid by clients were kept low.
Another key development was the shift from a single prime model to a multi-prime model to reduce counterparty risk, contradicting one of the advantages of prime brokers to provide a one-stop shop. Clients realized that no prime broker was too big to fail and spread their risk across several prime brokers, especially providers with strong capital reserves. However, the multi-prime model led to an increase in operational complexity and cost, requiring additional investment from money managers in incremental risk management processes and technology and resources to reconcile activity at different prime brokers. Thus, multi-prime has mainly been adopted by larger clients as it might be cost prohibitive for smaller money managers.
The prime brokerage model is very lucrative. Prime services offered by bulge-bracket investment banks are hard to replicate because they require considerable amounts of capital and strong balance sheets, as we discuss under ‘Characteristics of robust prime brokers.’ Hedge funds and other professional investors pay a variety of fees and spreads for an efficient point of access into capital markets through the core prime brokerage services listed below.
• Financing and Lending: Prime brokers provide both margin financing and securities lending services. Margin financing allows hedge funds to maximize the return on their investments by borrowing cash to buy securities. The financing is backed by the borrower's portfolio of assets held in their prime brokerage account as collateral. At a high level, a client with $100,000 worth of Apple shares may want to buy $50,000 worth of Amazon. The prime broker may provide a $50,000 loan, holding a portion of the borrower's Apple shares as collateral.
Securities lending is similar, but instead of lending cash to a client, a prime broker will directly lend stocks or bonds. Taking a short position in a stock is one of the main drivers behind borrowing securities. A borrower may short sell the loaned securities with the intention to purchase them at a lower price to repay the loan. The lending institution’s minimum collateral may be determined by factors such as regulatory requirements and the price volatility of the loaned securities and the assets pledged as collateral (if other than cash).viii Financing and lending spreads make up the majority of prime brokerage revenue;ix thus, clients who take on more leverage or engage in more short selling are more valuable.
Prime brokers may also provision leverage and synthetic exposure to assets via over-the-counter (OTC) derivatives such as contracts for difference (CFDs), total return swaps (TRSs), or portfolio swaps.x In a total return swap, for example, the prime broker would pay the client the total return on the underlying asset replicated by the contract (i.e. capital gains and any income generated by the asset). In the case of capital losses, the client would pay the broker in addition to any fees or interest on leverage.xi
• Trade execution: A prime broker provides access to several exchanges and markets through one platform, giving customers access to aggregated liquidity and optimal pricing. When a client wants to place a large trade, the prime broker's executing broker will locate a buyer or a seller. In evaluating execution venues, the broker has a legal obligation to put its client's interests first.xii They must consider various factors, including speed, pricing, safety, and fees to guarantee what is known as best execution. In addition to execution services, the prime broker will also handle the clearing and settlement of transactions. Prime brokers may charge trading commissions for executing buy and sell orders or earn a portion of the spreads. The exact revenue model differs based on whether the prime broker acts in an agent or principalxii capacity.xiv
• Custody: As custodians, prime brokers are responsible for the receipt, delivery, recording, and safekeeping of their client's assets. By providing custody and lending services under one roof, prime brokers can make it more seamless for clients to use their portfolio of assets as collateral for leverage. This allows prime brokers to offer borrowers larger loans than they would receive from other lenders at a moment's notice. Brokers can charge incremental fees for custody and clearing services.xv
In addition to core revenue-generating activities, prime brokers also offer clients a variety of concierge services for the firm’s valued clients.
• Capital introduction: Tapping into their extensive networks, prime brokers help facilitate relationships between hedge funds and potential clients. Additionally, they provide supplementary marketing and fundraising assistance to help drive new business.
• Risk management: Many primes have invested in risk management technology and services to help their clients efficiently manage their portfolios and map out potentially adverse situations.
• Reporting: With prime teams managing trading, financing, and custody, consolidated reporting is a necessity for clients. In one portal, prime brokers can offer aggregated and real-time portfolio analytics, daily statements, historical data, and additional custom reporting.
• Consulting: For young hedge funds, prime brokers may offer "start-up" services, including research and analysis, operational support, compliance training, and more.
• Point of access: The prime brokerage division of an institution also serves as a point of connectivity to other parts of the business, notably banking (deals and IPOs), sell-side research, sales and trading, and corporate access and conferences.xvi
Characteristics of robust prime brokers
In addition to considering the services prime brokers provide, money managers may evaluate and seek out certain characteristics in their prime brokers. These include, but are not limited to the firm’s credit quality, balance sheet strength, technology, reputation, and high-touch experience.
• Creditworthiness: Prior to the financial crisis, prime brokers were the ones concerned about the credit risk of their clients. After the global financial crisis, money managers realized they have equal reason to be cognizant of the credit worthiness of their prime brokers. This led them to seek service providers with a good credit standing and strong balance sheet.xvii
• Balance sheet: In the absence of the ability to self-fund the business through rehypothecation, prime brokers are reliant on access to the balance sheet of their parent company to fund the business (e.g. to lend to money managers)xviii. Prime divisions need access to balance sheet to provide compelling financing solutions, facilitate sizeable trades, and take on risk.
• Technology: Prime brokerage needs to be one of the most technologically savvy parts of a bank – it requires modern and upgradeable technology for trading and lending, integration into client systems, connectivity into other service providers and internal departments, accessibility to multiple markets and trading products, and real-time, custom reporting. Prime brokers also need cutting edge risk management technology because the firm’s balance sheet is at play. Additionally, prime brokers need to provide clients with seamless user interfaces that allow them to effectively track and manage their positions across assets and asset classes and make real-time decisions.
• Client service: Prime brokerage is a high-touch business as these service providers arguably determine the success of clients by helping them execute their strategies.xix They are the primary way that money managers access markets and other parts of a bank, finance activity, and maintain records. Another reason prime brokers are considered high-touch service providers is that they provide concierge services, such as capital introduction, consulting, and/or analytics. Given the white glove nature of prime broking, ensuring the client is a good fit is of utmost importance, especially given limited access to balance sheet under new liquidity and other regulatory requirements following the financial crisis (e.g. Basel III) and their impact on a prime’s profitability and returns.xx
These characteristics will likely be equally relevant to successful prime brokers servicing digital assets.
The importance of prime services for digital assets
Digital asset traders and investors realize they need a one-stop shop with the expertise to reduce risk and maximize returns in a nascent and volatile industry. To date, different digital asset firms have offered one-off services that, if combined, would fall under a fully integrated "prime services" umbrella. Service providers are recognizing the gap they can fill by stitching these services together to reduce the cost, complexity, and risks of participating in digital asset markets. While the importance of individual services provided may vary between traditional markets and digital asset markets, the purpose of a digital assets prime broker is the same – providing a streamlined, compliant, end-to-end investing and trading experience.
Custody is the "foundation of the [prime services] pyramid."xxi It is one of the key challenges that service providers had to solve to facilitate broader institutional involvement. While custody is important in a classic setting, safeguarding digital assets like bitcoin is paramount because, unlike traditional markets, there is no recourse if the assets are lost or stolen. Digital asset custody is also a highly technical undertaking and requires hardware, cybersecurity, and cryptographic expertise, that is not as relevant in the protection of traditional assets such as cash, stocks and bonds. Solving secure custody is necessary to effectively facilitating the following layers in the pyramid.
The next important component of the prime brokerage function is providing uniform access to multiple sources of liquidity. Liquidity in digital asset markets is siloed across many entities and products (e.g. spot and different types of derivatives – listed and OTC – with varying levels of regulatory oversight). Each platform also differs in parameters such as collateral requirements or liquidation methodology.xxii
Investors may choose to trade with a single or a few exchanges and OTC desks to avoid pre-funding on multiple platforms, reducing the operational and administrative complexity. The limiting of available liquidity creates challenges in achieving the optimal price. On the flipside, setting up accounts with multiple exchanges and keeping them funded presents counterparty risk from those platforms not specifically built to safeguard assets.
Assets in transit are at greater risk. Prime brokers that offer multi-venue execution or integrated settlement and custody solutions can help clients limit the movement of assets. Investors also need significant capital to pre-fund accounts on multiple trading venues, a function normally attributed to prime brokers. Additionally, investors cannot cross margin positions across exchanges, which increases the cost of capital. These challenges preclude capital efficiency.xxiii
A digital asset prime broker can address these limitations by enabling netted collateral and providing consolidated settlement – the ability to fund a single account and connect to multiple high-quality liquidity providers and exchanges. This also reduces the burden of each client having to individually conduct due diligence on multiple trading venues.
One layer up, prime brokers may offer financing solutions including lending digital assets to clients, facilitating leverage via synthetic exposure to the underlying, providing clients loans against the digital assets they hold, and helping clients generate returns on digital assets held long (by connecting them with borrowers or providing staking solutions) – these are all solutions that further improve the utility and efficiency of digital assets. Financing solutions that allow clients to borrow funds or borrow assets also reduce the costs of deploying more sophisticated and opportunistic trading strategies. Additionally, as money managers with active trading strategies enter digital asset markets, they may demand support for spot and derivatives trading side by side from firms positioning themselves as prime brokers.
Value-added services that institutional investors have come to expect in traditional markets could be relevant to digital asset prime brokerage. These services include capital introduction, corporate access/deals/events, consulting, portfolio and market data and analytics, and reporting tools, among others. Capital introduction could be an especially valuable concierge service for native digital asset hedge funds who don’t have access to asset allocators such as endowments, foundations, pensions, fund of funds and family offices in traditional markets. Another way that digital asset prime brokers could differentiate would be to provide access to deals in which a banking division may participate – e.g. digital asset company IPOs or ICOs.
Tying it all together, the ability to seamlessly trade spot and derivatives side by side with built-in financing can help bring down the costs of trading and investing in digital asset markets and make market participants more capitally efficient. To date, traditional institutional investors that have entered the space have mainly been interested in building long exposure to relatively more established assets such as bitcoin and their demands have been satisfied by custody and liquidity aggregation solutions for the most part. These institutions are starting to seek, out ways to generate returns on idle assets. Additionally, as large traditional hedge funds looking to deploy more complex trading strategies enter digital asset markets, they will demand incremental financing solutions and financial products.
Challenges and considerations
It is unknown where digital asset prime brokerage will settle and how service providers will address challenges they face, as there is no full-service digital asset prime broker today. As the industry matures and participants expand, it will be important to track approaches to the following unanswered questions.
• There is a lack of consistent regulatory standards governing rehypothecation, customer protection, credit standards, liquidity, and collateral management, etc. (factors that global bank and broker dealer regulations standardize) in digital asset markets. Will the lack of consistent regulation preclude large institutions from engaging with digital asset prime broker services? Is there an opportunity for an industry consortium to emerge and establish standards?
• Prime brokerage is normally the provision of trading and financing services to hedge funds. Will full service digital asset prime brokerage be applicable to multiple investor segments?
• Access to strong balance sheet is an important component of prime brokerage. How many firms are there in the digital asset industry today that can safely finance large trades?
• As there are few firms that can meet the demands outlined in this piece and offer full service prime brokerage, could the centralization of funds and activity present concentration risk?
• Firms offering prime services may trade principally and act as agent for clients. How can service providers ensure neutrality and separation of duties in trade execution?
• When managed appropriately, rehypothecation can improve market liquidity and create value for all stakeholders involved. How can clients confirm that service providers that may employ rehypothecation are transparent and have appropriate risk prevention practices in place?
Prime brokers are service partners that fulfill all core capital markets related needs. It would be a stretch to say a full-service prime broker with all the products and attributes of bulge bracket prime services teams in traditional markets exists in digital asset markets today. Rather, they are akin to boutique prime brokers that specialize in one or two specific prime services. However, service providers are recognizing the gap they can fill by bundling multiple products and services together. As market participants become more heterogeneous and sophisticated with the strategies they deploy, digital asset service providers will evolve in line to offer a comprehensive client experience. The stack of relevant prime services may differ between traditional and digital asset markets. While digital asset prime may not settle on the identical solutions provided by traditional prime, it will be rooted in an identical purpose – a master relationship that facilitates access to all relevant markets and service providers.
This article is for informational purposes only and is not intended to constitute a recommendation, investment advice of any kind, or an offer to buy or sell securities or other assets. Please perform your own research and consult a qualified advisor to see if digital assets are an appropriate investment option. Digital assets are speculative and highly volatile, can become illiquid at any time, and are for investors with a high risk tolerance. Investors in digital assets could lose the entire value of their investment.
[xiii]Principal refers to a model where the firm uses its own capital and securities to facilitate transactions. Agency refers to a model where the prime broker acts as an intermediary and arranges transactions between their clients (usually hedge funds) and institutional investors looking to trade or lend their assets.