PRA speaks on prime brokerage developments

Rebecca Jackson of the PRA spoke to UK Finance about recent dynamics in the prime brokerage sector, and the results of a recent PRA thematic review. Key points included:

• that the core of prime brokerage is financing – the prime broker will lend a client the money to go long a security, and then hold the security (almost always an equity) as collateral, or if the client wants to go short, the prime broker will lend them the security and take the proceeds of sale as collateral;
• prime brokerage can be either cash of synthetic – where total return swaps achieve the required economic effect;
• fundamentally prime brokerage is a function of scale – firms internalise by using one client’s collateral in another’s short position in the same equity, and so save money by not needing costly external financings or borrowing of securities. Obviously the bigger the firm, the easier it is;
• growth is fundamental to these markets and they have grown a lot over the past 10 years – the top 3 brokers now serve over 1000 funds each;
• in the shorter term there could come a point when pricing of prime brokerage resources increases, but in the longer term richer pricing could incentivise smaller players to increase their presence and encourage new firms to enter the markets. But the new firms may not have the infrastructure and risk management capabilities they need and should also be alert to the fact that the clients they acquire may be ones that the more established firms have elected not to keep;
• the PRA will focus its supervisory efforts on liquidity risk, operational resilience and counterparty credit risk. It is particularly keen to stress both that operational resilience is an ongoing and ever-moving challenge, and that firms must be sure they understand client risk profiles and monitor them. Recent incidents led the PRA to do a review of client risk disclosure standards, and found a lack of transparency and clear evidence of a link between the information a client provides and the risk appetite of the firm towards them. The PRA appreciates that there are few regulatory obligations on the clients to report or provide information, but says firms must make their assessments based on that the clients will or will not disclose.