How Are Clearing and Prime Brokers Different? 2024 Guide
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    Clearing Broker vs prime broker

    How Are Clearing and Prime Brokers Different? 2024 Guide

    Whether you’re a beginner in the financial markets or a seasoned trader looking to expand your knowledge, brokers are an essential subject you need to learn. Of course, many of us have a rough idea of what a brokerage is, but most people find it tricky to learn about different types of brokers.

    Two of the most common broker types you’ll bump into in 2024 are clearing and prime brokers. Each of these two play an essential role in the broad spectrum of financial markets.

    Clearing brokers are the financial bodies responsible for clearing, settling, and overall, handling trades. They work with large cleaning companies called clearing houses to ensure funds are transferred appropriately during trades. There are different types of clearing firms, including general clearing members, executing brokers, and clearing broker-dealers. There are also self-clearing broker-dealers who clear their trades independently.

    On the other hand, prime brokers comprise a set of financial services that institutions like large investment banks offer to complex trading operations, such as hedge funds. In its most basic form, a prime broker provides its clients with capital introduction, research, and risk management services.

    In this article from ITBFX, we will learn about prime and clearing brokers and their differences. If this sounds interesting to you, stay tuned!

    What Is a Clearing Broker?

    A clearing broker, AKA a clearing firm, is a middleman between investors and large corporations called clearing companies or clearing houses. These clearing companies are responsible for the smooth operation of financial markets, such as forex, and handle the confirmation, settlement, and delivery of transactions.

    Clearing Broker or Clearing Firm
    Clearing Broker or Clearing Firm

    Clearing companies and clearing brokers are connected through exchanges. While clearing brokers act as exchange members, these exchanges associate themselves with clearing houses to ensure the efficient handling of their transactions.

    A clearing broker’s main job is to ensure trades are settled appropriately, and transactions are successful. However, they are also responsible for documenting and archiving the paperwork associated with clearing and executing transactions. Man Securities and Wedbush Securities Inc. are two of the largest clearing firms in the world.

    Clearing Firms vs. Broker-Dealers

    As mentioned before, clearing firms, or clearing brokers, ensure the proper transfer of funds and confirm and settle trades. However, broker-dealers are financial bodies that participate in trading on behalf of their customers and themselves. In essence, clearing firms are responsible for handling trades sufficiently, while broker-dealers partake in trading themselves. Additionally, a clearing broker should always be a firm or official business, whereas broker-dealers can consist of a singular person.

    What Does a Clearing Broker Do?

    Clearing brokers have become the glue that holds the different parts of financial markets together. The main functions of a clearing broker include ensuring the market’s dependability and efficiency, conducting research, and confirming the information they are given to manage transactions better.

    As mentioned before, a clearing broker handles market orders and ensures they run smoothly. However, they are also responsible for maintaining the custody of account holders’ securities and other assets, including the cash they have in their accounts. When a market order is executed, clearing brokers manage the funds associated with transactions to make sure that they are being handled and transferred appropriately. It’s important to know that clearing brokers utilize the services offered by clearing houses to make sure the market is operating smoothly, the trades are settled appropriately, and transactions have been successful.

    Providing these services enables clearing firms to bring simplicity, reliability, and efficiency to financial markets, which is why many consider these institutes to be the backbone of the market.

    In addition to clearing trades and transactions, clearing brokers research the information exchanges have given them and confirm that this information is accurate.

    Types of Clearing Brokers

    There are three main types of clearing brokers, each with different functions. They include general clearing members, executing brokers, and self-clearing brokers.

    General Clearing Members

    General clearing members are intermediaries between trading parties and central clearing companies or clearing houses. Their main job is to facilitate trade settlements by matching buy and sell orders together. However, they are also in charge of making sure that trading parties are compliant with the rules imposed by the clearing house they work with, hence taking responsibility for risk management.

    Executing Brokers

    As the name suggests, executing brokers are responsible for executing trades on behalf of other traders and investors. They focus on placing buy and sell orders at the best available prices in the market. Executing brokers offer their services to retail and institutional traders and investors. Although they’re viewed as a type of clearing broker themselves, executing brokers usually rely on services provided by a third-party clearing broker (like general clearing members) to facilitate post-trade processing.

    Self-Clearing Brokers

    Self-clearing brokers are among the most comprehensive clearing brokers available. They handle all aspects of the clearing process internally, including trade execution and settlement. To assume full responsibility for clearing and settlement functions, self-clearing brokers often have direct relationships with larger, more mainstream clearing companies.

    As expected, running a self-clearing broker is not an easy job. One needs significant infrastructure and resources to do so. However, self-clearing brokers also have far better control and flexibility over the clearing process of transactions and trades.

    Types of Clearing Brokers
    Types of Clearing Brokers

    What Kinds of Fees Do Clearing Brokers Charge?

    The basis on which clearing brokers can make money varies, but most brokers calculate their fees in two ways. They either charge a fixed rate for a certain amount of time or charge clients based on the value of the assets they handle. Clearing firm charges include clearing fees, settlement fees, and custody fees.

    Clearing Fees

    As mentioned before, clearing brokers process and clear trades through central clearing houses and companies. To cover the costs of this process, clearing brokers charge a clearing fee, which is charged per transaction. To calculate the exact amount of the payment, clearing firms consider several factors. These factors include the type of asset that’s being traded, the total volume of trades executed, and the additional services offered by the firm.

    Settlement Fees

    Clearing brokers may also collect settlement fees, which are designed to cover the costs of trade settlement and security transfers between trading parties. Like clearing fees, settlement fees are calculated on a per-transaction basis.

    Custody Fees

    Clearing brokers charge custody fees to cover the costs of holding and protecting the assets of their clients. They also include the costs of facilitating asset transfers, maintaining custody accounts, and providing safe, secure storage for clients. When calculating the custody fees charged by a clearing broker, one might face a fixed periodic charge (like a monthly or annual subscription fee) or a percentage of the entire value of the assets the client has in the custody of the broker.

    Fees Charged by Clearing Firms

    What Is a Prime Broker?

    Designed to facilitate large, complex trading operations, a prime brokerage consists of various services that large financial bodies, like big investment banks, offer clients, such as hedge funds. These services include, but are not limited to, asset lending and cash management.

    Prime brokerages function similarly to a central broker that mainstreams and coordinates extensive trading operations and evolves a variety of trading instruments. Among the most popular prime brokers in the world, Goldman Sachs and JP Morgan Chase could be named.

    What Does a Prime Brokerage Do?

    As mentioned before, prime brokers might offer various services to their clients. In this section, we will discuss some of these services and how they can help hedge funds and other clients of these institutes. First, we will examine the core custodial and financial services offered to prime brokers’ clients. Then, we will take a look at their other add-on services, also known as concierge services.

    Essential Services Provided by a Prime Brokerage

    One of the primary jobs of a prime broker is acting as a liaison between hedge funds and two fundamental counterparties:

    • Large institutional investors: As they have massive equity holdings, these investors can help hedge funds with their short-selling purposes. Hedge funds aim to establish relationships with large institutional investors so that they can borrow capital from them.
    • Commercial banks: These banks also have sufficient funds available and can benefit hedge funds by making large loans and helping them with their margin purposes.

    By connecting hedge funds to these two substantial counterparties, prime brokerages provide large-scale short-selling opportunities. Hedge funds can borrow capital from large institutional investors and maximize their profit through leverage by taking advantage of the margin financing options offered by commercial banks.

    Prime brokers also may partake in trade clearing and settlement, taking the job of a clearing broker to an extent. While hedge funds may have accounts in several brokerage firms, they usually execute and clear their trades through a predetermined prime broker, which helps simplify the reporting of transactions and streamline the hedge fund’s operations. The prime broker manages to reach these goals by playing the role of a custodian for the hedge fund’s assets, removing the complexities of the process of borrowing capital. Doing so makes it possible for the hedge fund’s assets to be quickly shifted to the prime broker as collateral.

    Other Add-on Services Provided by Prime Brokers

    Prime brokerages might offer their clients additional resources, which are usually called “concierge services.” These resources are provided to hedge funds to help them enhance their operations.

    One of the most critical concierge services offered by prime brokers is risk and performance analytics. These brokers usually partner with risk management companies to provide hedge funds with daily risk and performance reports.

    They also provide asset managers with capital introduction, which facilitates the process of introducing them to potential investors.

    Another resource offered by prime brokers is access to their derivatives trading desks, which give them access to a wide variety of derivatives and risk management suggestions. This is especially beneficial for hedge funds, which often trade derivative instruments with high risk and return rates.

    Moreover, prime brokers’ clients can access the private research services and resources provided by the brokerage, which enhances their operation and reduces research costs.

    Overall, hedge funds and other complex trading operations can take advantage of the services provided by prime brokers to outsource their activities and focus on making more money.

    Prime Broker Services
    Prime Broker Services

    Types of Prime Brokers

    Just like clearing brokers, there are three main types of prime brokers that we will discuss in this section of the article. These brokerage types include traditional, synthetic, and full-service prime brokers.

    Traditional Prime Brokers

    These brokers facilitate the borrowing of funds using more mainstream, traditional financial instruments such as stocks. Because they don’t work with derivatives or financial structures, traditional prime brokers usually have a much smaller operation size.

    Synthetic Prime Brokers

    These prime brokers typically work with structures and synthetic financial instruments, which are created to imitate specific financial instruments while making changes in key characteristics.

    Synthetic prime brokers usually work with over-the-counter (OTC) and exchange-traded derivatives. The sheer size of the international derivatives market alone makes synthetic prime brokers extremely successful and in demand.

    Full-Service Prime Brokers

    Usually run by large investment banks, full-service prime brokers combine the services offered by both traditional prime brokers and synthetic prime brokers, providing customers with a large spectrum of resources.

    Types of Prime Brokers
    Types of Prime Brokers

    How to Choose the Right Prime Broker?

    Choosing the right prime brokerage may be confusing to hedge fund managers. However, you can easily choose the best prime broker for you by considering three key factors:

    1. The most crucial factor in choosing anything is the price of it. Do your research on the price of services provided by different prime brokers and find some brokers within your budget range.
    2. You should also pay attention to the selection of services that your prospective prime broker of choice offers. This is especially important for new hedge fund managers who are looking for significant investors.
    3. Additionally, the ideal prime broker will quickly provide you with access to large security holders, especially those who have less liquid and more difficult-to-borrow instruments.
    4. Lastly, you should pay attention to the level of confidentiality the broker provides for your trades.

    Wrap-Up: Clearing Vs Prime Brokers

    Clearing brokers, also known as clearing firms, are intermediaries between clearing companies and exchanges. They are responsible for clearing trades and ensuring the market’s reliability and efficiency. They also keep a record of these trades and conduct research on the information they’ve been given by exchanges.

    Different types of clearing firms have various functions. For instance, a general clearing member facilitates trade settlement by matching buy and sell prices and ensuring regulatory compliance in trading parties. On the other hand, an executing broker is in charge of, well, you guessed it, executing trades on behalf of clients. They place orders at the best available prices in the market. We also have self-clearing brokers who can independently clear trades and not rely on other clearing firms. Lastly, there are self-clearing broker-dealers that not only clear trades independently but also participate in trading themselves.

    On the other hand, we have prime brokers, which offer a bundle of services to clients running complicated financial operations. The typical prime brokerage client is a hedge fund looking to borrow capital and receive other services. These services include, but are not limited to, risk management, research, and clearing services.

    There are three types of prime brokers: traditional prime brokers, synthetic prime brokers, and full-service prime brokers. Each one of these brokers caters to the needs of a specific niche of clients.

    In this article, we went over cleaning brokers, prime brokers, and the differences between them. We learned about the different types of services offered by each one and found out how to choose the best prime broker. If you’re interested in learning more about financial markets and how you can get started on them, we strongly suggest you head over to our blog at ITBFX and start learning right now!

    A clearing firm, or clearing broker, is a financial entity responsible for clearing, settling, and handling trades. Clearing firms are considered the backbone of financial markets, as these markets owe their reliability and efficiency to them.

    A self-clearing broker-dealer or clearing broker-dealer is a clearing firm that can not only clear trades executed within another exchange but also execute and clear its own trades.

    A prime broker is a selection of services that investment banks, wealth management companies, and other major financial bodies offer to hedge funds and other clients.

    Prime brokers offer diverse services, including capital introduction, regulatory advice, research and analysis, and custodial services.