Clearing and Execution
Financial Clearing and Execution Services
Clearing is one of the most basic services provided by a prime broker. Loader (2002) gives an in-depth analysis for the clearing and settlement services in the general financial markets. When a prime broker is hired to carry out clearing, he performs back office functions on behalf of the hedge fund client with the broker-dealer that executed the trade.When the hedge fund begins the trade, the fund provides the executing broker with the prime broker's name and the relevant account with the prime broker. Respectively, the executing broker gives-up the trade (meaning, passing the trade information) to the prime broker, and the hedge fund reports the allocations of the trade to the prime broke. The prime broker then performs a post-trade matching, confirms the trade with both sides if the trade details match. Otherwise, the prime broker works with the hedge fund and the executing broker to resolve the differences.
For the hedge fund, the choice of the executing broker includes but is not limited to the trading desk of the prime broker. (A broker-dealer must maintain a "Chinese Wall" between the prime brokerage operation and the trading desk.) If a prime broker acts as principal in the give-up process, the prime broker allows the hedge fund to trade under the prime broker's name and assumes the role of the hedge fund with respect to the executing broker. On the other hand, the prime broker plays the role of the executing broker with respect to the hedge fund, for all future cash flows associated with the trade. The prime broker could also act as agent, in which case the prime broker clears and settles the trade on behalf of the hedge fund but does not assume counterparty risk. Principal prime brokerage is most common in the foreign exchange, OTC derivative and credit markets. Exchange or cash traded securities are usually cleared on an agency basis.
In 2008, the financial crisis has proven the need for the multi-prime brokerage model. According to Sameer Shalaby, CEO of Paladyne Systems, "(hedge fund) firms should consider that establishing relationships with multiple prime brokers can spread the risk that their assets will be in jeopardy if another crisis arises." (full article)
The process for a hedge fund to clear through multiple prime brokerage firms has been made easy, thanks to the available technologies. In as early as 2003, three leading foreign-exchange prime brokers - Deutsche Bank, JP Morgan Chase and AIG Trading - have casted aside competitive differences and teamed up to create an online service for automating the "give-up" trade process, "to help (executing brokers) give up their transactions electronically not just to one prime broker but to all (of their) prime brokers"(more). Ron Suber, head of global sales and marketing and a senior partner at Merlin Securities, explains in an article dated Oct 2008 that Merlin's technology allows funds to aggregate data from different prime brokers on one system. "That has led to Merlin picking up dramatic new business given its multi-prime services."
By Yifei Huang
Sources: Hedge Funds and Prime Brokers; Fixed Income Prime Brokerage: Agency Model
