Prime brokerage is a colloquial term for a number of different relationships between large securities dealers and banks and their clients. There are two main ways in which derivatives trading is relevant to prime brokerage and both typically have different collateral management arrangements. (1)
Derivatives Prime Brokerage
Derivatives prime brokerage describes an arrangement where a client has agreed with its derivatives prime broker that it will be able to execute derivatives transactions with a number of nominated executing dealers but that upon execution, the trade between the client and the executing dealer will immediately be given up or novated to the prime broker, who becomes the executing dealer’s counterparty; at the same moment, a new back to back trade on exactly the same terms arises between the prime broker and the client.
There is little or no standardization of derivatives prime brokerage agreements but, generally speaking, they deal with issues such as scope for client to execute trades with executing dealers, remuneration and the ability to adjust the client trade to reflect changes in the dealer trade. Such an agreement may also include collateral provisions. These range from simply accelerating delivery times in the credit support arrangement to in some cases carving certain trades out of the definition of “Exposure” in the credit support arrangement and setting out a bespoke margin or collateralizaton calculation model. (2)
Classic Prime Brokerage and Cross Margining of Derivatives
Classic prime brokerage is the provision of securities custody and clearing services by prime brokers combined with the provision of cash and securities lending to facilitate use of leverage and short exposure by clients, typically hedge funds. Prime brokerage services are usually governed by a bespoke prime brokerage agreement that includes margining and collateralization provisions in relation to the cash and securities lending.
Derivatives are used by prime brokerage clients for several reasons including to hedge economic risks created by the fund’s activities in physical securities or to replicate the performance of holding a physical investment, or trading under a derivatives prime brokerage arrangement described above. Ordinarily a client would post collateral under the prime brokerage agreement for its physical securities activity and a separate amount of collateral under a … credit support arrangement in respect of its derivatives exposure.
However, where derivative positions held by a prime brokerage client operate to reduce risk or
offset exposure of physical positions held by the client, or vice versa, when considered on a “whole portfolio” basis, prime brokers may offer to cross margin and cross collateralize the physical and derivative transactions, thereby reducing the amount of collateral that is required into a single lower amount. In such cases the derivatives transaction remains governed by the ISDA Master Agreement but the trades to be cross-margined are typically carved out of the definition of “Exposure” in the credit support arrangement.
These trades are then included in the prime brokerage margin calculation and will
be used to determine a single amount that the client is required to maintain in its prime brokerage account against its consolidated exposure. This collateral will usually take the form of securities and cash held in custody by the prime broker and subject to a pledge or charge. Whilst the securities or cash are generally subject to client money and client asset protections in the hands of the prime broker, the prime broker may also have a right to use or rehypothecate such securities or cash subject to an obligation to redeliver equivalent collateral upon satisfaction by the client of their liabilities to the prime broker.
Documenting cross-margining arrangements such as those described above can be done by simply amending the relevant ISDA Master Agreement and prime brokerage agreements but is more commonly achieved by using a form of master netting agreement. In addition to cross margining prime brokerage and OTC positions bilaterally, arrangements to cross margin physical positions at the prime brokerage entity with OTC positions held at an affiliate company of the prime broker are becoming more common. Master cross netting and cross guarantee structures are the most commonly used methods for documenting such arrangements. (3)
- Market Review of OTC Derivative Bilateral Collateralization Practices. International Swaps and Derivatives Association – March 1, 2010
- Financial Risk
- Collateral Asset
- Credit Support
- Credit Risk
- Prime Rate
- Back-To-Back Letter Of Credit
- Prime Maker
- Customhouse Broker