What is a prime broker?

Prime brokers earn mainly from the spreads on the cash and securities they lend, plus trading commissions, rather than a flat fee for the bundle. The loans are secured by the fund’s positions, and in some places and structures the broker may reuse that collateral, known as rehypothecation. When a large prime broker failed in 2008, some hedge funds that had borrowed from it could not get their collateral back.

Say a fund has $100 million of its own and its prime broker lends it $50 million, secured by the fund’s positions. The fund can then hold $150 million of investments. Simple example. Terms vary by fund.

A fund’s borrowing and its assets can sit with its prime broker, so the terms of that lending and the broker’s own soundness are part of an investor’s risk.