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Prime Brokerage: The Business Hedge Funds Cannot Operate Without

Beginner Investing • 6 min

When Lehman Brothers collapsed in 2008, hedge funds that had done nothing wrong — that hadn't made a single bad trade — still got frozen out of their own money. Because Lehman was their prime broker, and when a prime broker fails, the assets and collateral it's holding for you can get tangled up in the bankruptcy. A prime broker is a division of a big bank that provides the plumbing a hedge fund needs to actually operate: lending cash to trade with leverage, locating and lending shares so the fund can short-sell, and holding custody of the fund's assets.

Insider Angle: almost no hedge fund strategy works without this plumbing — and because prime brokers hold your assets, your fund's fate is partly tied to your broker's health, not just your own trading skill. That's exactly why most serious hedge funds today use two or three prime brokers instead of one.
Try This: If a fund had 100% of its assets with a single prime broker that suddenly failed, versus a fund that split assets across 3 prime brokers, work through what happens to each fund's ability to keep operating in the following week.
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