As electronic trading technology improves, and brokers and clearing firms compete for assets and order-flow now more than ever, it is increasingly important for a portfolio manager to understand what the major prime brokers offer, and how this can impact their fund’s business. Many of the largest prime brokers advertise that they offer integrated solutions, specifically tailored to the needs of today’s fund managers. But what does tailored really mean? In this article, we will examine some of the critical factors a portfolio manager should consider when choosing where to house fund assets, and how this can directly impact a fund’s costs and capabilities.
Routing & Technology
It is imperative for a trader (or quant-jockey) to have access to the appropriate order management and trading tools required to effectively execute a fund’s strategies. For example, quantitative, event-driven trading, may require your prime broker to interface with your existing trading and messaging engines, via such protocols as FIX. Alternatively, you may have a need to execute large lists or baskets from a file format generated by your traders, and therefore might require a front-end interface for importing and managing these lists intra-day. For block-order or single-order entry strategies, you may require the ability to direct orders to specific destinations, or to use special order types such as cancel/replace, or conditional orders. Or for modeling or developing new strategies, you may need the ability to back-test against historical market data and an execution simulator. Understanding a prime broker’s trading tools, connectivity and execution capabilities may not only impact the cost of trading, but may determine whether or not your strategy can be effectively executed at all.
Clearing & Reporting
While a prime broker may offer a host of trading software and tools to choose from, if these tools are not seamlessly integrated with their clearing formats and processes, it can create headaches for the compliance, accounting and trade-reconciliation staff. For example, if you use an execution tool that is not integrated with your prime broker, you may be required to extract your trades, reformat them into the prime broker’s format, and then upload them manually at the end of each day. This can often result in more trade breaks and incorrect position reports, which can in turn increase market risk and affect P&L. In addition, it is important to know what reporting packages the prime broker can provide. Ideally, real-time or daily electronic access to your positions, execution history, trade research, and breaks files, by account or across a fund or fund family, is a good base to start from. The more customizable the reports, the easier it will be to provide the fund administrator with the information they need to produce investor statements, run NAV calculations, and so forth.
Allocations & Managed Accounts
For multiple managed accounts, it may be important to have trades allocated across those accounts on a percentage basis after they have been traded, as attempting to trade multiple accounts "pari passu" can result in divergent returns. For this reason, it is important to understand if the prime broker has a method of parsing and allocating trades after they have been executed, but before they are cleared and settled. In addition, if your fund allows for redemptions or accepts new capital monthly or quarterly, your prime broker should be able to adjust trade allocation percentages accordingly. Finally, you may need to make trade adjustments across managed accounts based on these reallocation percentages, and so your prime broker should have a means of either journaling or crossing these trades efficiently and cost-effectively. Some firms have developed flexible post-trade allocation and crossing processes that are utilized by prime brokers specifically for handling these issues.
For strategies that require leverage, it is important to understand your broker’s margin capabilities and how they handle margin. Some firms do not offer enhanced leverage (above standard Reg. T), while others offer enhanced leverage products (4:1 or 6:1+), but require you to maintain two sets of accounts (long and short), because they move the shorts off the books. This means you may have to separate out the trading of your long vs. short trades, and have a means of consolidating end-day and morning positions reports to know where you stand "net" across the fund. And if you do decide to use a prime broker’s enhanced leverage product, be sure that their trade execution, order management and allocation tools can properly settle your trades to these dual-accounts. Otherwise, you may end up with issues to deal with like boxed positions or misallocations.
In such instruments as options, futures, derivatives, foreign exchange and distressed securities, it is important to inquire as to whether the prime broker offers execution and order management tools for these products, and if they can clear them properly and cost-effectively. While some prime brokers claim to offer a variety of trading platforms, they may in fact be "third party" products, in which case they may not be completely integrated with the clearing process. This can create additional work for your traders or technology staff in terms of end-of-day file uploads, trade reconciliation, and morning position imports, which in turn make adding trading capabilities both cumbersome and time-consuming. You should also ask whether the prime broker provides access to research, and whether that research is in-house or simply resold from other providers.
Customer Service & Transitioning
The biggest risk, and often hurdle, for a fund to overcome when deciding to move from one prime broker to another, is the transition process. The more your new prime broker can help you make the transition gradual and seamless, the lower the risk. For starters, your new prime broker should assign a dedicated transition contact that hand-holds the entire process; from the implementation of new trading and execution tools, to the movement of positions, to the testing, configuration, and training of clearing, reporting and allocation formats and processes. This will ensure that trading and fund performance is not disrupted during the move, and that your traders, fund administrators and compliance staff have the knowledge and tools they need to feel comfortable with the new prime brokerage relationship before the transition occurs. In addition, the new prime broker should offer a simple way to DVP trades back to your old prime broker accounts in a cost effective, seamless manner, so that you can transition accounts, assets and positions over time, and test the new relationship out instead of making a big leap. Once the transition process is complete, you should have access to a dedicated relationship manager, trading desk, technology group, and clearing contacts to support your fund as it grows and adapts to market conditions.
As a general rule of thumb, prime brokers that offer components in each of the areas we have discussed, and have tools and processes that link them together smoothly, will be better able to tailor their services to meet the specific needs of your fund both now and in the future, and ultimately offer the best pricing package for your particular type of business.
Typically, there are five ways for a prime broker to make money: clearing, execution, lending and securities lending, software, and proprietary product. If the prime broker can make more revenue off of one, it may offer better rates on the others. In the current market, clearing and execution rates are often priced as a variable rate per-share, based on volume and average trade size. This can be as an "all-in" rate (inclusive of liquidity-taking fees, exchange fees, Specialist charges, etc), or as a base cost plus pass-through rate. Some prime brokers may also offer a clearing "max ticket", where the clearing fee is capped at some maximum dollar amount per trade, for such things as large block orders. Lending rates are usually set at the broker call rate, plus some basis-point markup, which declines with high debit balances. For securities lending, the prime broker will typically make an interest spread on securities it lends for the purposes of short selling. The size of your prime-broker’s total debit balances will often determine how competitive they can be on your margin rates. Software can be priced at a fixed monthly rate per user login, inclusive or exclusive of market data fees, and depending on who owns and provides the software application, the prime broker may provide you with access free of charge, or may rebate the monthly software cost based on some minimum volume threshold. Generally, the closer the relationship between the prime broker and the execution/software provider, the more likely it is that the prime broker can "subsidize" execution or software costs for its clients, in favor of lending or proprietary product revenue. This is because the prime broker can take advantage of its own economies of scale across all the clients it supports, whereas you as a fund manager might have to foot a higher bill by paying a third party software vendor or execution vendor directly, based on your individual trading volume levels. Proprietary products, such as derivatives, IPOs, or research, are customarily offered on an individual or subscription basis, and are often priced based on demand and the perceived value of the products themselves.
To get the most "bang" for your buck, the key is to understand which costs have the most significant impact on a fund’s performance and return, and get the best rate there while ensuring that other costs stay competitive. For example, if a strategy calls for significant short selling while carrying high debit balances with low turnover, you should be more concerned with the prime broker’s lending rates, and less concerned with getting a lower variable rate for execution. Alternatively, if you run a high-volume strategy concentrated in a relatively small universe of securities, requesting a "max ticket" for clearing may be to your advantage in minimizing clearing costs. Just remember, there is no free lunch, and if a certain cost seems "too good to be true", chances are the prime broker is making it up with a higher rate somewhere else.
What To Look For
The best prime brokers today offer a suite of execution and order management products designed specifically for different trading strategies, all of which automatically capture, format and upload your trade data seamlessly for clearing purposes, and deliver electronic copies to you for end-of-day reconciliation. These products are linked directly to back-office systems that can handle changing trade allocation instructions, crossing, trading-away, DVP to outside managed accounts, and enhanced leverage products with dual-accounts. They may also provide web-based access to your positions and executions files the next morning prior to market open, a dedicated, knowledgeable transition and relationship management team, and access to a variety of financial products under their umbrella. As a result, they can customize a pricing schedule that truly is tailored to your funds’ needs.