Synthetic prime brokerage gains traction as regulatory landscape shifts

What is synthetic prime brokerage?

Synthetic prime brokerage gives hedge funds economic exposure to securities without direct ownership through derivatives contracts, primarily total return swaps (TRS). The prime broker pays the hedge fund the "total return" on a reference asset (e.g., capital gains and dividends) while the hedge fund pays fees, capital losses and interest on any embedded leverage.

Unlike traditional cash prime brokerage, where funds physically own securities, synthetic arrangements create the same economic effect through swap contracts. The client never actually owns the share; instead, the swap dealer buys it and passes on the economic return under an equity derivative.

Key advantages driving adoption

Easier setup through ISDA agreements

For hedge funds, synthetic offers an easier setup than physical prime brokerage, using International Swaps and Derivatives Association (ISDA) agreements as the industry standard,¹ this streamlined process eliminates many complexities associated with traditional custody arrangements.

Enhanced anonymity and flexibility

Fund positions can be kept anonymous (pending regulatory changes), as any hedges are held in the name of the prime broker. Additionally, modern synthetic prime brokerage, like IG Prime, offers extensive market coverage with over 17,000 markets and 24/5 pricing on major indices, FX pairs, commodities and cryptocurrencies.

Capital efficiency under Basel III

Under the Basel III framework, the ability of banks to hedge and net derivative positions results in capital and liquidity costs for synthetic financing that are lower than those for traditional securities financing. This regulatory advantage has become increasingly important as banks face tighter capital requirements.

Operational considerations

While synthetic prime brokerage offers compelling advantages, prospective clients should carefully evaluate several operational considerations. Margin management requires particular attention, as margin is not always dynamic in synthetic positions – a primary reason for the Archegos failure was an inability to manage swap margining rules. Additionally, financing costs accrue on the full value of the notional position in a synthetic, which may make a good rate less attractive than the total charge.

However, leading providers have addressed many traditional technology challenges by developing sophisticated platforms. Advanced systems now enable DMA execution using native, synthetic and algorithmic order types supported by Tier 1 bank smart order routing technology, while supporting third-party trading access via FIX, MT4, API and Bloomberg EMSX.

Market growth and future outlook

Hedge fund assets reached a record $4.46 trillion globally as of Q3 2024, according to HFR, representing continued growth in the industry driven by new investor inflows and strong performance.² This growth is driving increased demand for both traditional and synthetic prime brokerage services.

Synthetic versus cash prime brokerage is not an all-or-nothing proposition. It may be appropriate for funds to have both types of relationships, including trading cash and synthetic products with the same prime broker counterparty.

Choosing the right provider

When evaluating synthetic prime brokerage providers, institutional investors should consider regulatory standing, technology capabilities, market access, and operational support. Established providers with strong Tier 1 bank partnerships and comprehensive platform capabilities often provide the stability and innovation necessary for successful long-term relationships.

Conclusion

Synthetic prime brokerage represents a significant evolution in how hedge funds access leverage and manage trading relationships. Driven by regulatory changes under Basel III and operational advantages, this model is creating lasting changes in industry practices. Fund managers who understand both the benefits and limitations of synthetic arrangements will be better positioned to optimise their strategies in an increasingly complex regulatory environment.

For institutional investors exploring synthetic prime brokerage solutions, partnering with experienced providers that offer comprehensive technology platforms, such as IG Prime, extensive market access, and strong regulatory credentials will be essential for success in this evolving landscape.

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References

¹ https://finadium.com/whats-better-for-hedge-funds-synthetic-or-cash-prime-brokerage/

² https://www.ig.com/uk/prime/insights/research-and-strategy/state-of-the-industry-report-2025