The past few months have brought a lot of light into what the financials are all about, how much risk they had on their books and some of the downside they had. A lot of these new informations brought out some questions and many had to do with the prime brokerage business.

In theory, it is a simple and safe model for all parties involved. An investor or fund does not want to take care of the back office, settlements, accounting, etc. So they simply use a prime broker such as Goldman Sachs, Morgan Stanley, etc. They will simply send all of their trades at the end of each day to their broker. The broker will make sure the trades settle, issue reports at the end of every day about the cash, market value, and trades in the specific accounts. Simple enough?

Wait it gets better. A good example would be an equity fund that uses a prime broker. Usually there are a few sources of income for the prime broker. First off, if the fund uses electronic trading, they might be using the one offered by the prime broker. Execution commission comes in. Then, the fund manager might want to do some FX hedging. Since it is not a primary activity, they do not have much contacts and will usually do them through their PB (Prime Broker) which will collect on those through spreads.

So that’s how they make those profits? Hmm well, there is one other thing. If you have a fund that has $500 millions and is invested to 80%, then that is about $100 millions in uninvested funds. The prime broker will often keep those funds and pay out interest on those funds to the fund.

So where’s the problem?

What if you are a fund manager, have these $100 millions and hear that the prime broker you are using is investing those funds to get higher returns? And what if part of those investments are in leveraged vehicules? That works and is fine until the moment where confidence is shattered which is exactly what happened a few months ago when companies such as Citibank and Morgan Stanley were having major problems and their stocks were going in one direction, down. What happens if you had money at Lehman in your fund? Well unfortunately, you are out of luck. Sure, you will probably get most if not all of it back because of segregation rules. But it might take a long time and it will certainly make any client of that fund VERY nervous.

So what has happened now? Well, first of all, a lot of fund managers are rethinking how to deal with prime brokers. One of the differences is that funds tend to leave a lot less money at prime brokers, deciding to invest those funds theirselves or invest them in safe securities such as US TBills. That is one of the factors that contributed to yields under or close to 0% in recent months on some issues.

So what does that mean for Prime Brokers? Well, with less hedge funds and probably less profit per fund because of these changes, it probably means a big drop in revenues. How much? Tough to say, but I’m staying clear for now!