Prime Brokerage Risk Defined

• Prime brokerage activities consist of services that an investment bank provides to a hedge fund. These services may relate to processing trades on financial exchanges and security lending transactions. For example, an investment bank may buy and sell corporate stocks, bonds and derivative instruments on behalf of a hedge fund. Prime brokerage risk is the risk of loss that may originate from a client's failure to reimburse debt or meet other monetary commitments because of bankruptcy or temporary financial difficulties.
  
  

Types

• Prime brokerage risk is implicit in a financial institution's transactions with a hedge fund at the operational level. For instance, an investment bank's securities processing department may fail to notify a hedge fund about trade settlements. Brokerage risk also may be inherent in compliance mechanisms such as tools that the bank uses to conform to Securities and Exchange Commission (SEC) rules. Prime brokerage risk also may be credit risk, or the risk of default from a business partner.
  
  

Risk and Control Assessment

• A financial institution that provides prime brokerage services typically ensures that relevant controls are in place to prevent losses in operations. Top management periodically requires departmental heads to issue a risk and control self-assessment (RCSA) report to ensure that internal controls are adequate and functional. A control is a list of recommendations that senior management puts into place to prevent prime brokerage losses. An RCSA report ranks internal risk events as "high," "medium" and "low" based on loss expectation.
  
  

Financial Risk

• Prime brokerage activities often may cause a bank or an insurance company to incur credit losses. Credit risk, also known as counterparty risk, is the risk of loss arising from counterparty (business party) defaults. Assume a bank provides prime brokerage services to a hedge fund and lends the fund $150 million for financial market transactions. If the hedge fund files for bankruptcy after six months, the bank may lose $150 million if it is unable to recover any amount in court.
  
  

Compliance Risk

• Types of regulatory guidelines regarding prime brokerage services vary, depending on the company size and the legal status of counterparties. These regulations help firms and industry overseers manage financial risks at the firm and industry levels. A U.S.-based investment bank may have to conform to SEC, New York Stock Exchange (NYSE) and Financial Industry Regulatory Authority (FINRA) rules when providing prime brokerage services. Internationally, the bank may need to comply with International Swaps and Derivatives Association (ISDA) requirements.