Prime brokerage is the part of an investment bank that services hedge funds. It provides custody (holding the fund's securities), securities lending (lending out the fund's long positions and lending in securities the fund wants to short), financing (margin loans against the fund's positions), capital introduction (introducing the fund to potential institutional investors), and operational support.
How a prime broker makes money
The economics are large but tight: prime brokerage runs on net interest margin (the spread between what the bank pays to borrow and what it charges hedge fund clients to finance their positions) and securities-lending fees (the rebate the bank keeps on stock loans). A hedge fund client with $5B in assets and 3x gross leverage is generating millions in annual revenue for its primes through interest, financing, and stock-loan fees.
Goldman Sachs and Morgan Stanley have historically been the two largest prime brokers, each with roughly 25-30% market share. JPMorgan, Barclays, and Bank of America make up the rest of the top tier. Hedge funds typically use 2-3 primes simultaneously — concentrating with one bank creates concentration risk, but spreading too thin loses access to the best service tier.
The Archegos lesson
The Archegos collapse in March 2021 was the cautionary lesson. Bill Hwang's family office had built $30B+ in synthetic equity exposure through total-return swaps with multiple prime brokers. When margin calls hit, the unwind cost the banks $10B+ in aggregate losses — Credit Suisse $5.5B, Nomura $2.9B, Morgan Stanley $911M. Goldman and JPMorgan unwound their positions faster and largely escaped. The episode revealed that even with apparently sophisticated risk management, banks can be carrying enormous concentrated exposure to a single client across multiple desks without anyone connecting the dots.
Exercise
A new African hedge fund is raising USD 200m of capital and shopping for prime-broker services. They have narrowed the choice to Goldman Sachs and Morgan Stanley. (1) What services do they get from the prime broker beyond execution? (2) What are the trade-offs of consolidating with one prime vs splitting across two or three? (3) Two years after the Archegos collapse, what additional due diligence should the prime broker do on this client before opening the relationship? (4) Roughly what revenue does this hedge fund generate for the prime broker in a typical year, assuming 2-3x gross leverage?