Prime Brokerages and DeFi — Part 1
What is a Prime Brokerage?
Throughout the global chaos of 2020 emerged a massive influx of retail interest in personal trading and investment. Many of our readers, no doubt, know of or have utilized discount brokerage services such as Robinhood, Charles Schwab, and E-Trade. But we noticed that not everyone may be aware of what prime brokerages are, though they may have encountered the term in the news or during their own research.
This might be because prime brokerages traditionally cater to sophisticated financial players, including hedge funds, investment banks, pension funds, and asset managers. But technology and structural shifts in lifestyles is changing what’s accessible to who. Young people have embraced stock trading and retail traders make up 20% of US equity trades this year. Paypal and Square now allow transfers in crypto assets. DeFi and yield farming have taken the crypto space by storm.
We firmly believe that global adoption of new financial services, made possible by decentralized finance, is on its way. And these decentralized services will include those offered by prime brokerages — once the exclusive domain of the financially privileged.
At risk of jumping the gun, we claim that prime brokerage services matter for individuals and that DeFi will place such services in their grasp.
What exactly is a prime brokerage, and why do its services matter for you and me?
Our point today is not to jump you with boring technicals; we can do that another time. Allow us to start with a cut and dry definition, before shifting to prime brokerage in the crypto space — something that can make you money and transform your control over your finances.
A brokerage, as you know, is a third-party institution who acts as an intermediary between buyer and seller. A prime brokerage refers to such a registered broker-dealer intermediary which offers a set of specialized services for financial institutions, including:
Centralized custody. Custody means temporary ownership of a client’s assets for protection, oversight, and the provision of value-added services. Custody of a fund’s assets allows a prime broker to execute quickly on trades for that client while simplifying their financial reporting. More importantly, custody allows prime brokers to offer clients seamless access to lending services.
Lending of securities and cash. Clients can use their portfolios held at the prime brokerage as collateral to borrow currency, for example. This gives the clients leverage, which is the financing of a client’s position to amplify possible gains (or losses). Being able to borrow securities is also important if clients intend to short sell, i.e. bet that a security’s price will decrease.
Furthermore, the prime broker can collateralize a client’s portfolio to raise cash at an attractive rate and lend this cash to a different participant (e.g. a hedge fund) at a mark-up. The hedge fund receives the cash they want to borrow, and the collateralized portfolio receives part of the interest that the hedge fund pays back. The lending of cash or securities for these purposes is known as margin or trade financing.
Likewise, in servicing a client who wants to short sell, the prime broker will happily borrow the securities in question from an asset manager (at a cost) and lend them to the short seller (at a higher cost, pocketing the difference). The short seller receives the security they need to borrow and the lending asset manager receives yield for their service.
Leveraged trade execution. Leverage here means being able to make a trade of a certain size without paying the full amount of that holding (the degree to which borrowed money is used to finance the position). This is also known as trading on margin.
Clearing. As fund managers often trade with multiple brokers, having a designated prime broker means these executing brokers can settle all trades with the single prime broker. The alternative is otherwise to manually maintain all these accounts across multiple brokers.
The prime broker thereby simplifies the fund manager’s interface and the reporting process. This netting of trades into a single consolidated ‘point’ reduces the fund manager’s risk exposure and fees. (On a more technical point, a large hedge fund — think over $1 billion AUM — may employ multiple prime brokerages).
The largest investment banks possess well-known prime brokerage business units: Goldman Sachs, Morgan Stanley, J.P. Morgan, Credit Suisse, Citi, and Bank of America Merrill Lynch, just to name a few.
Prime brokerage in the crypto, DeFi space:
Needless to say, prime brokerages are accessible only to financial institutions with assets exceeding hundreds of millions of dollars. The effort required by prime brokers to build and maintain specialized relationships means that they will target only large institutions to offer their services. So where does the average citizen fall in here?
As the crypto space has grown in popularity, so too has demand for decentralized financial services similar to those enjoyed in the centralized realm. Decentralized finance players have picked up on this demand and are competing to innovate and meet users’ needs.
Imagine having the following at your fingertips:
Yield generation. The ability to deposit your excess funds and earn yield on these assets by automatically lending them out at market rates.
Borrowing and obtaining liquidity. The ability to borrow the assets you need from someone else’s pool, seamlessly paying interest to that pool.
Trading leverage. Obtaining the margin financing required to achieve otherwise unattainable performance by automating an otherwise tedious cycle of collateralizing, borrowing, and collateralizing what’s borrowed, up to your desired leverage.
Many, if not all, of these functionalities will be extremely familiar concepts. The problems with traditional offerings for these services have to do with accessibility (who can use them), fees (how much you pay), and seamlessness (how intuitive is the interface you’re using).
Can such power be yours? Yes, thanks to DeFi and initiatives like the Oxygen Prime Brokerage protocol.