Most hedge funds remember 2008 about as fondly as a visit from the feds. The collapse of Lehman Brothers Holdings slammed many of their positions — and for some, froze their prime brokerage accounts. Managers also had to live down the unraveling of Bernard Madoff’s $65 billion Ponzi scheme.
The resulting emphasis on risk management drove many hedge fund firms to seek custody accounts to safeguard assets against counterparty failures, says George Sullivan, Boston-based global head of alternative investment solutions at State Street Corp., which has $28.7 trillion in assets under custody.
Other factors have contributed to the flight to custodian banks. The U.S. Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 and Europe’s Alternative Investment Fund Managers Directive of 2011 require hedge funds to use a third-party custodian. Institutional investors, which tend to have more rigorous transparency requirements and governance around asset allocation, have also come to dominate the hedge fund client base, forcing firms to ramp up risk management even more. “The risk benefits of a custody account really compelled their being used more than they had in the past to manage and mitigate risk,” Sullivan notes.
Global custodians are benefiting greatly from hedge funds’ attention. By contrast, prime brokers and administrators are pulling back from or exiting the space in the face of regulatory capital requirements that reduce returns on equity and thus shrink banks’ margins. State Street bought Goldman Sachs Group’s administration unit in 2012; this June, BNP Paribas Securities Services closed its purchase of Credit Suisse Prime Fund Services. The acquired clients spill over into custody services.
Lehman’s implosion gave custodians the opportunity to fill a vacuum by stepping up with prime services alongside their custody offerings. The result: a cheaper and more efficient trading model for hedge funds. “In the immediate aftermath of the Lehman bankruptcy, one of the key concerns of hedge funds and asset managers generally was safe custody of assets and transparency,” says Paul Hamill, global head of prime finance at HSBC Holdings, which has $6.4 trillion in assets under custody. Hedge funds, particularly those that short-sell or use leverage, rely on prime brokers to trade securities. Now, when a client buys a stock and holds it with HSBC’s prime services business, the firm keeps that stock in a custody account. “Clients take a great deal of comfort from that,” London-based Hamill notes.
Prime brokerage is a meaningful component of a hedge fund strategy, says State Street’s Sullivan, who oversaw the purchase of the Goldman unit. State Street is trying to complement that service by offering products and actions that allow hedge fund managers to present a risk-managed proposition to their investors, he explains. “The better they do that, the more they’re able to distribute and the more attractive they are to investors.”
Securities lending helps drive the efficiency of the relationship between prime brokerage services and custody offerings. Among other things, it allows hedge funds to short-sell, or trade borrowed securities on the belief that the stock’s value will fall. Having a bank hold the lendable assets under custody rather than rely on a third party to borrow them makes the transactions more affordable, streamlined and transparent. “From an investor point of view, a global custodian has to be a credible provider in securities lending in order to have a credible global custody product,” says Roy Zimmerhansl, Hong Kong–based global head of securities lending at HSBC Securities Services.
A worldwide presence is important for custodians. But for Zimmerhansl, “Technology is the only thing that allows you to reach out through a global platform and service customers everywhere.” For example, in 2009, State Street introduced Enhanced Custody, a tool that lets managers diversify their counterparty exposure by allowing the financing of short positions through a custody account. “That strategy, alongside the events of 2008, from State Street’s perspective, really amplified our hedge fund custody business in a big way,” Sullivan says.
As Hamill of HSBC notes, “Hedge funds are a very important part of our franchise.” The synthesis of custody and prime brokerage keeps business coming in, says colleague Zimmerhansl: “The more pieces you have in the puzzle, the better the client proposition.”
Follow Georgie Hurst on Twitter at @Ghurst_iimag.
Get more on hedge funds and alternatives .