In the low-risk, back-to-basics market environment ushered in by the financial crisis, custodian banks have emerged as a safe haven for hedge fund assets. The collapse of Lehman Brothers in September 2008 highlighted the risks hedge funds take on by keeping cash and long assets in a commingled prime brokerage account.
It could be years before hedge funds are able to recover the assets frozen by the administrator as part of the bankruptcy proceedings. Those that had their assets rehypothecated by Lehman will have to join the queue of unsecured creditors. By contrast, assets held in custody accounts are segregated and protected in the event of a bankruptcy.
Hedge funds transferred billions of dollars in unencumbered cash and long securities into custody accounts in the days and weeks following the Lehman failure as they sought a sanctuary for their assets in the market turmoil.
"The first step taken by most hedge funds was to move cash to a safer environment," says Huw Williams, global segment head for hedge funds for JPMorgan Treasury & Securities Services. Then hedge funds started to ask questions about the safety of the cash posted as collateral for initial margining.
"That led to greater demand for services like custody and tri-party collateral management," says Williams.
Most custodians have existing links to hedge funds through their fund administration units. These relationships have now been expanded to include custody of long assets and cash and collateral management.
"Almost one third of our hedge fund administration clients are now using us as the custodian for their long assets," says Gary Enos, executive vice president at State Street, which has over $250 billion in hedge fund assets under administration.
Surviving the crisis
Custodian banks see themselves playing a bigger role in the hedge fund industry as it emerges from the financial crisis. On a practical note, the reduced level of leverage available to hedge funds has diluted their reliance on prime brokers and made it easier to transfer assets into custody accounts.
"If a hedge fund is not employing leverage, there's really nothing to stop them from moving their business to a custodian bank. Investors will probably be very comfortable with that," notes Dennis Westley, managing director of alternative investment services at PNC Global Investment Servicing.
At the same time hedge funds are under pressure from investors to appoint independent administrators and provide greater transparency and reporting. Westley says custodian banks have the tools to help hedge funds provide the level of transparency and reporting that regulators and investors are increasingly demanding.
Custodians have well-established fund administration units and have developed risk, performance and regulatory reporting services for institutional investors which could be adapted to the needs of hedge funds.
"We can provide an extensive set of reporting tools for hedge funds and their investors. It is really up to the hedge funds to decide how much transparency they can live with. To a large extent that may be decided by the regulatory environment," says Westley.
The move to a multi-prime model, which has become standard practice for hedge funds since the Lehman failure, has also created additional demand for the middle-office support services and reporting capabilities of custodian banks. The current demand for custody services among hedge funds poses interesting questions for both custodian banks and prime brokers.
In June, Morgan Stanley launched a custodial service for hedge funds. Prime brokerage clients will have the option of placing their long securities in a custody account provided by the bank's chartered trust company, Morgan Stanley Trust National Association (MSTNA). "Recent market events have increased the demand for solutions that mitigate counterparty risk for hedge funds," says Rich Portogallo, head of institutional clients and services at Morgan Stanley.
Creating a hybrid
For banks like JPMorgan and Citi that have both prime brokerage and custody units, there is a clear opportunity to exploit the relationship between the two business lines. JPMorgan has developed a hybrid service through which fully funded long positions are held in a custody account at the bank while the assets used to fund short positions or gain leverage remain with the prime brokerage unit.
"We have worked closely with our colleagues in the prime brokerage business to develop this product," says Huw Williams, global head of sales for JPMorgan's hedge fund services business. He says the service has been well received in the US, and is gaining traction in Europe.
Citi was one of the first custodian banks to identify a role for itself as an intermediary between hedge funds and prime brokers in the multi-prime landscape. It has developed a number of services which exist in the space between prime brokerage and custody.
In 2006 Citi launched a product called 'open prime'. This acts a single front-end gateway through which users can access multiple prime brokers. It was a bold move at a time when the large banks were still fiercely competing for their share of the prime brokerage pie.
The financial crisis and the shift to a multi-prime environment has validated the strategy. The bank has since added a collateral optimisation service to the open prime platform. This is essentially a set of analytical tools that can help hedge funds use their assets across multiple counterparties more efficiently, explains Chandresh Iyer, head of global custody and investment administration services at Citi.
The bank is now developing another service called 'prime custody'. The idea with this is to look at the convergence between the two business lines and create an environment where assets can be seamlessly transferred between a custody account and multiple prime brokers, depending on the specific needs of the client. Iyer describes it as a "cross-over service between traditional prime brokerage and custodian services".
Citi's goal is to create a flexible, end-to-end operational support platform for hedge funds. As a result the bank launched a middle-office outsourcing service in May 2009, which essentially plugs the gap between open prime and its custody and fund administration services.
"The lines that separated custody and prime brokerage in the past are blurring. We are in an ideal position to take advantage of that because we view the business from the perspective of both a large custodian bank and a prime broker," says Iyer.
Custodian banks without prime brokers have to take a different approach. These banks have historically focused on servicing institutional investors and long-only managers. The lines of demarcation between traditional and alternative investment styles have been blurring for some time, believes Olivier Laurent, director, alternative investments product management at RBC Dexia Investor Services.
He says several hedge funds, including Brevan Howard and GLG Partners, have launched Ucits-compliant absolute return products which take advantage of the increased flexibility of the Ucits III framework. Under the revised Ucits rules introduced in 2007, asset managers can use over-the-counter (OTC) derivatives like contracts for difference and equity swaps to employ leverage and take short positions.
"It took some time for hedge funds to find the right model to launch Ucits products," says Laurent.
Ucits funds must appoint an independent depository bank for the safekeeping of assets. They must also use an independent agent to value OTC derivatives and have processes in place to monitor and measure their risk exposures.
These requirements opened the door to custodian banks to work more closely with hedge funds as they launched Ucits products. At the same time traditional long-only managers launched products like 130/30 funds which borrow ideas from the alternative investment world.
Laurent believes the financial crisis has accelerated the trend towards regulated products like Ucits. "Institutional investors have a huge amount of comfort with Ucits. Hedge funds are responding to that," he says.
The vast majority of hedge funds are still established offshore, but Laurent says this is changing. RBC Dexia currently administers around $30 billion in hedge fund assets. Laurent estimates that around 10% of this is in Ucits products. "However, around 80% of the hedge funds launched in the past six months that RBC Dexia services have been Ucits structures," he says.
RBC Dexia has seen greater demand for its custody and collateral management services from traditional offshore hedge funds in recent months. Laurent says RBC Dexia plans to expand the range of services it provides to hedge fund managers and investors. He sees an opportunity for the bank to play a bigger role in the managed accounts sector.
In Europe this business is dominated by the managed account platforms of Lyxor and Credit Agricole. Laurent proposes an alternative model whereby clients can create a personal managed account platform, with custody, administration and middle-office services provided by RBC Dexia.
"The assets would be independently administered and held in custody accounts at RBC Dexia, rather than at the prime broker of the underlying hedge fund manager. There are additional services that we can provide, like risk management and monitoring of investment restrictions and controls, as well as middle-office services," he says.
State Street has perhaps the most aggressive strategy for competing directly with prime brokers for hedge fund business. The bank has developed what Enos calls an "enhanced custody service" for hedge funds. In addition to basic custody, the service includes foreign exchange, cash management and securities lending services. State Street also plans to give hedge funds access to leverage through swaps. It is a bold strategy, but one that could pay dividends.
State Street runs the largest agent lending program in the world and is the main supplier of loan stock to prime brokers. In the past its securities lending clients - institutional investors like pension funds - were unwilling to approve hedge funds as counterparties, preferring instead to lend to the large banks.
Prime brokers passed the stock on to hedge funds, often at a large mark-up. But Enos believes attitudes towards this pricing model may be changing. "As hedge funds become more institutional, with independent custodian banks and administrators, they become more attractive as counterparties," says Enos.
RBC Dexia already offers this type of service in Canada but not in the US or Europe. If the company can find the right model, with which hedge funds and institutional investors are comfortable, securities lending could be the trump card for custodian banks seeking to expand their business with hedge funds.
Spoilt for choice
Enos believes custodians have a bigger role to play in the hedge fund industry. Looking to the future he says, "Instead of one-stop shopping at a single prime, hedge funds will choose from an a la carte menu of services from multiple prime brokers and custodian banks."
BNY Mellon has a different strategy. Instead of competing directly with prime brokers, its aim is to provide services that address the weaknesses in the prime brokerage model. A few years ago, the bank integrated its alternative investment and broker/dealer services units with a view to developing products that address the inter- relationships between those client segments.
"For hedge funds BNY Mellon provides a range of services that help them to deal with counterparty and operational risk issues and improve the way they do business. But importantly we are also working with prime brokers to help them evolve their model and meet the requirements of their clients," says Rick Stanley, executive vice president at BNY Mellon.
Stanley says prime brokers can diffuse concerns about counterparty risk by referring hedge funds to use BNY Mellon for cash and collateral management and custody of long securities. "They can use BNY Mellon as an independent safe house. That will allow them to continue doing business with their hedge fund clients without having to radically alter their business," he says.
At the same time BNY Mellon is open to working directly with hedge fund clients and offers a suite of services from simple custody and cash management through to margin and collateral management services. The objective, Stanley says, is not just to offer greater safety and security but to help hedge funds improve the way they interact with prime brokers.
"For example, our tri-party services provide transparency into the collateral process and can help hedge funds to be more efficient in the way they fund themselves," says Stanley.