The New Prime Custody

Terry Flanagan

Custodians have become increasingly pro-active in building services for hedge fund clients.

Hedge fund assets available for prime custody services now stand at $684 billion, a 40% increase since 2010, according to a report by BNY Mellon and research firm Finadium. The increase reflects growth in overall hedge fund assets under management as well as lower levels of borrowing from prime brokers.

Prior to the credit crisis, hedge funds that had custodial assets were simply considered clients alongside pension plans, mutual funds and other groups.

The classic definition of the term ‘prime custody’ referred specifically to accounts set up in conjunction with a prime broker to move excess, unencumbered long positions for safekeeping to a prime custodian.

Following the crisis, however, hedge funds began to pay much more attention to who held custody of their assets and their counterparty risk profiles.

“Traditionally, hedge funds custodied assets with their prime broker,” said Marina Lewin, managing director at BNY Mellon Alternative Investment Services. “The prime brokerage model got questioned following the 2008 credit crisis, and as a result, hedge funds have chosen to take advantage of the custodial model, with is purely long-only in terms of how we hold the assets. It becomes segregated from the prime brokerage pool of assets; we do not rehypothecate.”

‘Prime custody’ refers to the tailored servicing of assets within alternative investment portfolios performed by both prime brokers and custodians to provide greater transparency and risk mitigation.

Roughly half of all hedge funds with more than $1 billion in AUM are now thought to have a prime custody arrangement in place, up from 15% in 2009, as funds seek to mitigate counterparty risk, according to the BNY Mellon/Finadium report.

Most custodians now have dedicated service teams focused on their hedge fund clients.

“Whereas the focus of prime custody has traditionally been on unencumbered assets, it has evolved to where we now offer products” such as securities lending and other services, said Lewin. “This new definition of prime custody recognizes hedge funds as a distinct client base with different needs than a pension fund or mutual funds.”

BNY Mellon’s prime custody platform enables hedge funds to move, manage and safekeep assets with maximum transparency, combining elements of custody with collateral management and liquidity services.

“Assets are fully segregated and held outside the custodian’s balance sheet, helping to address investor concerns regarding counterparty risk,” Lewin said.

The evolution of prime custody takes place against a backdrop of tightening profit margins and greater cost of capital for banks, as they prepare for the Basel III capital accords.

“Basel III will leverage the impact of the second wave Basel II effort to model risk more accurately,” said Michael Baker, senior director at S&P Capital IQ. “It can also lead banks to a new focus on improving credit methodology and accuracy, rather than systems and technology, as banks confront increasing capital costs and a difficult business environment.”

Regulations such as the Alternative Investment Fund Manager Directive (AIFMD), as well as changes in collateral management brought on by the movement of OTC derivatives to central clearing, have had a direct impact on the growth of prime custody.

“The assets we hold under prime custody have grown as a result of AIFMD, by which a custodian will have to be appointed that has control over underlying assets,” Lewin said. “The changing dynamics of regulations will drive prime custody.”

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