Attention needs to be paid to custody risk, warns Odey Asset Management chairman

Operational Risk
10 Dec, 2012

Hedge fund managers need to pay more attention to custody risk, the chairman of Odey Asset Management has warned.

This comes as a growing number of managers are putting unencumbered assets into custody accounts. A report by BNY Mellon and Finadium revealed assets held in prime custody had jumped by 40% to $684 billion since 2010. Half of all hedge funds running in excess of $1 billion now have a prime custody agreement in place, up from 15% in 2008. Fears over counterparty risks and reduced borrowing from prime brokers have been the main drivers behind the model’s growth although there is a growing concern many managers view custodians as risk free. This, said David Fletcher of Odey, was ill advised.

“While safer than the traditional prime brokerage model, the custody model is not immune to failure be it through fraud or issues spreading from other areas of a custody bank. Look, for example, at the client custody assets at Lehman, Peregrine Financial and MF Global. Outside of the broker dealer community, the chance of a custody banking group failing and having custodied assets being stolen and lost may be remote.  But the key issue remains – what clarity is there over the return of assets held in custody in the event of a custodian failure? Would the liquidator return all of the assets held in custody immediately?” he asked.

The situation could be exacerbated if a custodian used client assets as collateral in a time of crisis. As has been witnessed several times now, segregated client assets have been used by banks as collateral in crisis situations. Custodians also have a charge on hedge fund assets meaning these assets can be lent out. Were a custodian to default, it could be a serious challenge for managers to obtain those assets.

“Imagine a typical scenario for a failed custody bank where it turns out that clients’ asset records are incomplete, and there is talk of, if not the reality of, fraud. A liquidator may rightly be leery of distributing people’s assets in short order. Custodians generally have a charge over client assets. Even if this was originally intended to secure unpaid fees, it presents a further challenge to the risk-averse liquidator,” commented Fletcher.

“Not having access to assets for a several months would destroy most hedge funds. The biggest counterparty risk we have is to our custodian but simultaneously it is the least likely risk to occur,” he continued.

Managers could prevent custodians from taking a charge over their assets by demanding such a policy be engrained in their custody agreements although custodians have been reluctant to oblige. Furthermore, policymakers need to find a legal solution to clarify how assets held in custody can be recovered painlessly in the event of a default.

“Just like the living wills of the too big to fail banks, the authorities should have a clear answer to policy in the case of a failed custodian. Leaving it to the liquidator is insufficient. In the meantime custodians should do their bit for clarity by giving up their spurious charges over client assets,” said Fletcher.

Odey Asset Managementcounterparty riskcustody riskBNY MellonFinadiumcollateralMF GlobalPeregrine FinancialLehman Brothers