Several types of brokerage functions are needed to ensure smooth operation in financial markets.
In todays electronically connected world, your trade order may be executed within mere seconds. However, a number of complex processes occur in the background, involving both primary brokerage as well as custody-related functions. In some instances, a single broker may provide both functions, and in other cases, two entirely separate institutions may be involved.
A prime broker is the institution you interact with when you pick up the phone or log on to an Internet site and place a trade order. Similarly, it is the prime broker who will arrange a loan that you can use for leveraged trading, which is a fancy term for buying and selling financial assets with borrowed money. Prime brokerages compile and report your trading activity to the tax authority, send your tax statements at the end of the year and keep records that can be used in case of disputes. Most prime brokers also provide investment advice.
The custodian, also known as custody provider, keeps possession of the assets. You can think of the custodian as the safe box to which your prime broker has access but only with your express consent. Back in the day when stock certificates were printed on paper, custodians used to actually store them. Today, most storage is handled electronically. However, an institution must still manage the flow of money between buyers and sellers. When you sell a stock, the custodian transfers the electronic entry representing stock certificates to the buyers account and accepts the cash on your behalf from the seller.
Setting up a prime broker involves far less investment than founding a custodian brokerage company. A prime broker can merely have a few employees to answer phone calls and a limited number of workers to keep track of paperwork. Investors may have a hard time trusting such a small entity for the safekeeping of assets, however. A custodian, on the other hand, is usually a nationally recognized institution, with a long history and established brand name. Custodians are also closely monitored by federal as well as local authorities to avoid fraud, errors and insolvency.
A broker can also supply both prime brokerage as well as custody services. Such companies generally have lower cost per transaction, because they do not have to pay outsiders for custody functions and, therefore, offer competitive commission rates to investors. To recoup the large cost associated with setting up a custody infrastructure, they usually supply custody services to several prime brokers, as well. Prime brokers, with their higher costs and the resulting higher commission rates, tend to cater to a select, high-net worth clientele. These brokers often differentiate themselves by providing personalized attention to each client.
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Hunkar Ozyasar is the former high-yield bond strategist for Deutsche Bank. He has been quoted in publications including Financial Times and the Wall Street Journal. His book, When Time Management Fails, is published in 12 countries while Ozyasars finance articles are featured on Nikkei, Japans premier financial news service. He holds a Master of Business Administration from Kellogg Graduate School.
Ozyasar, Hunkar. The Differences Between a Custodian & a Prime Broker.
Ozyasar, Hunkar. (n.d.). The Differences Between a Custodian & a Prime Broker.
Ozyasar, Hunkar. The Differences Between a Custodian & a Prime Broker accessed April 19, 2019.
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