role of dealer banks in the primary market is to intermediate between issuers and investors, to provide liquidity, and to act as underwriters of investments. In secondary securities markets, large dealer banks trade with one another and with brokers/dealers directly over the computer or the phone, as well as play an intermediating role of facilitating trades.
Large dealer banks also engage in proprietary trading. Proprietary trading occurs when a firm trades securities with its own money in order to make a profit. Large dealer banks serve as counterparties to OTC derivatives such as options, forwards, and swaps that require the participation of a counterparty dealer who meets customer demand by taking the opposite side of a desired position. Dealers may accept the risk or use a matched book dealer operation, in which the dealer lays off the derivative risk by taking an offsetting position.
As part of their business management activities, large dealer banks are active as prime brokers that offer professional services specifically to hedge funds and other large institutional customers. (Prime brokers are discussed in more detail in section 2.1.3.) Several large dealer banks have ventured into off-balance-sheet financing methods, a practice that involves a form of accounting in which large expenditures are kept off the company's balance sheet through various classification methods. Companies use off-balance-sheet financing to keep their debt-to-equity and leverage ratios low.
In addition to their special role in the financial system, large dealer banks share many of the same responsibilities as conventional commercial banks, including deposit taking and lending to corporations and consumers.
BROKERS: Also on the sell side are retail brokers that receive commissions for executing transactions and that have research departments that make investment recommendations. Advantages of using brokers include their expertise in the trading process, their access to other traders and exchanges, and their ability to facilitate clearance and settlement. Because brokers play the role of middlemen in the trading process, traders can use broker services when they want to remain anonymous to other traders. Typically, traders can manage their order exposure by breaking up large trades and distributing them to different brokers or by asking a single broker in charge of the entire trade to expose only parts of the order, so that the full size remains unknown to other traders. Brokers also often represent limit orders for clients (i.e., orders placed with a brokerage to buy or sell shares at a specified price or better). In this event, brokers monitor the markets on behalf of their clients and make decisions based on client limit and stop orders when the markets change.
The brokerage firm's proprietary trading operations involve the firm's own account, called the house account. Other sources of broker revenue include soft commissions, payments for order flow, interest on margin loans, short interest rebates (on short sales), underwriting fees when the firm helps clients sell securities, and mergers and acquisitions (M&A) fees. The major cost of running a brokerage firm is labor: the brokers and other employees who provide the firm's services to clients.
Brokerage firms and other firms with major investment activities organize their activities into three major operations: (1) front office, (2) back office, and (3) middle office. Front office operations involve investment decision-making and, in the case of brokerage firms, contact with clients. Back office operations play a supportive role in the maintenance of accounts and information systems used to transmit important market and trader information in all trading transactions, as well as in the clearance and settlement of the trades. Middle office operations form the interface between the front office and the back office, with a focus on risk management.
2.1.3 Outside Service Providers
Other major participants in the world of alternative investments are outside service providers, such as prime brokers, accountants, attorneys, and fund administrators. Alternative investment funds rely on outside service providers for their successful creation and operation. Details regarding outside service providers are provided in Chapter 31, and their roles are briefly discussed here.
PRIME BROKERS: Prime brokers allow an investment manager to carry out trades in multiple financial instruments at multiple broker-dealers while keeping all cash and securities at a single firm. The prime broker has the following primary functions: clearing and financing trades for its client, providing research, arranging financing, and producing portfolio accounting. Prime brokers offer a range of services, which are discussed in more detail in Chapter 31, on due diligence.
ACCOUNTANTS AND AUDITORS: The accounting firm providing services to a hedge fund or to another alternative investment fund should include an experienced auditor and tax adviser. During the creation of the fund or investment vehicle, the accounting firm provides services largely parallel to those of an attorney: reviewing legal documents to ensure that accounting methods and allocations are appropriate and feasible, and that relevant tax issues have been addressed. The accountant helps prepare partnership returns and the necessary forms for the investors in the fund to report their shares of partnership income, deductions, gains, and losses (e.g., Schedule K-1 in the United States). The adviser also provides tax-related advice to the fund throughout the year and may be called on as a consultant on structuring and compensation issues for the principals of the general partner. The auditor performs a year-end audit of the fund, including the review of security pricing, and presents the results of this audit to the fund and its investors. Accountants usually cooperate with the prime broker and fund administrator to gather the necessary information for audits and tax returns.
ATTORNEYS: An attorney helps determine the best legal structure for a fund's unique investment strategies, objectives, and desired investors. The attorney takes care of filing any documents required by the government (federal or other levels) and creates the legal documents necessary for establishing and managing a hedge fund or another alternative investment, including (1) private-placement memoranda (a.k.a. offering documents), which are formal descriptions of an investment opportunity that comply with federal securities regulations; (2) a partnership agreement, which is a formal written contract creating a partnership; (3) a subscription agreement, which is an application submitted by an investor who desires to join a limited partnership; and (4) a management company operating agreement, which is an agreement between members related to a limited liability company and the conduct of its business as it pertains to the law. The attorney can offer guidance on marketing a hedge fund or another alternative investment in full compliance with all legal requirements, as well as on operational issues, such as personal trading. For example, in the United States, an attorney can provide advice regarding Securities and Exchange Commission (SEC) rules governing the use of testimonials, performance statistics, and prior performance statistics.
FUND ADMINISTRATORS: Many hedge funds and other alternative investment funds now engage a fund administrator to be responsible for bookkeeping, third-party information gathering, and securities valuation functions for all of their funds, both onshore and offshore. The fund administrator maintains a general ledger account, marks the fund's books, maintains its records, carries out monthly accounting, supplies its monthly profit and loss (P&L) statements, calculates its returns, verifies asset existence, independently calculates fees, and provides an unbiased, third-party resource for price confirmation on security positions. The same administrator also produces a monthly capital account statement for investors, and apportions fund income or loss among them. The administrator takes over the duties of day-to-day accounting and bookkeeping so that managers can focus on maximizing the portfolio's returns. The administrator can also be an important source of information for the auditor and tax adviser in completing required audits andtax returns.
HEDGE FUND INFRASTRUCTURE: Hedge funds can require a complicated infrastructure and extensive technological systems. The infrastructure may have three main components: (1) platforms, (2) software, and (3) data providers. Financial platforms are systems that provide access to financial markets, portfolio management systems, accounting and reporting systems, and risk management systems. Financial software may consist of prepackaged software programs and computer languages tailored to the needs of financial organizations. Some funds use open-source software, and others pay licensing fees for proprietary software. For a hedge fund, most of the raw material that goes into its strategy development and ongoing investment process is in the form