Prime Broker vs. Custodian

Brokers and custodians, along with clearinghouses, are the primary trade facilitators in a trading cycle. While brokers initiate trades and clearinghouses settle them, custodians provide access to and control over client assets used in trading. Brokerage services may be integrated with custody and trade settling, but such trade integration can present conflicts of interest.

Small and mid-size brokers often provide services only to small, individual investors and some limited institutional clients while relying on other trade service providers for asset custody and trade clearance. Prime brokers serve large institutional clients, such as hedge funds, and wealthy investors. A prime broker often has the ability to offer other trade services, such as custodian and clearance, in a way that adds convenience for clients to manage their trading accounts.

Traditionally, a custodian is a third party that brokerages use to provide safeguards to their customers' trading assets to eliminate any concerns that customers may have about the safety of their money. A custodian takes physical possession of the trading assets: certificates of securities -- paper and electronic -- and any cash. Without the approval of the custodian, a broker cannot gain access to customer assets. This helps prevent mishandling of customer money by a broker.

Trade integration refers to the handling of different aspects of trade services by a single broker, most likely a prime broker. Different brokerage customers often have different demands on how their brokers should provide various trade services. Institutional clients of various investment funds may prefer more timely information on their trades as opposed to the safety often preferred by individual clients. By combining brokerage services and custodian services -- and clearing services if necessary -- a prime broker can make trading more effective for clients.

Without the checks and balances provided by a third-party custodian, a prime broker offering both brokerage services and asset custody may have a conflict of interest between serving its clients' interest and pursuing its own interest. The primary concern that such a prime broker's clients should have is how their money is still safeguarded. To assure clients that their broker will not misuse their assets for his own account, a prime broker may offer custodian services through a separate legal entity of his brokerage's subsidiary, providing speedy trade services and reducing conflicts of interest.