← Back to Learn Investing

Prime Brokerage: The Business Hedge Funds Cannot Operate Without

Beginner Investing • 6 min

What this lesson is about

The unglamorous service. Lending stock, lending cash, holding assets. That quietly makes almost every hedge fund strategy possible.

2 parts · a quick check after each · then the quiz

Part 1 of 2

When Lehman Brothers collapsed in 2008, hedge funds that had done nothing wrong got frozen out of their own money. They hadn’t made a single bad trade. Yet, they suffered. Lehman was their prime broker. When a prime broker fails, the assets and collateral it holds for you can get tangled up in bankruptcy. A prime broker is a division of a big bank that provides the plumbing a hedge fund needs to operate. They lend cash to trade with leverage, locate and lend shares for short-selling, and hold custody of the fund's assets.

What borrowing does to both endsThe same multiple on the way up and the way down.

Quick check

A hedge fund wants to short a stock (bet it will go down). What does it typically need from its prime broker to do this?

Part 2 of 2

Insider Angle: Almost no hedge fund strategy works without this plumbing. Since prime brokers hold your assets, your fund's fate is partly tied to your broker's health. It’s not just about your trading skill. That’s why most serious hedge funds today use two or three prime brokers instead of relying on just 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, think about what happens to each fund's ability to keep operating in the following week.

Quick check

What is 'leverage,' in the context of a hedge fund borrowing money from its prime broker to increase its position size?

Quiz

Master this lesson

Test what you just learned. Correct moves you up, wrong moves you down - reach 100 to master this lesson.

0
/ 100
Log in to save your progress and earn XP.

Related lessons

Swipe for more
What Is a Stock? Understand what a stock represents and how ownership in a company works. 4 min Beginner What a Trading Desk Actually Looks Like on a Normal Day It's not a room full of people yelling 'Buy! Sell!' anymore. It's mostly quiet people staring at 6 monitors. Here's what actually happens. 6 min Advanced How Investment Banks Make Money on IPOs, and Their Built-In Conflict of Interest Banks get paid a percentage of every IPO they underwrite. Which creates a real conflict when they're also the ones telling you what the stock is worth. 6 min Advanced