COO Webinar on prime custody and asset protection: Key Points
The webinar hosted by COOConnect agreed that the financial crisis of 2007-08 had put the traditional model of prime brokerage to a severe test, which it had not passed.
This has prompted the growth of a variety of so-called prime custody services, which offer segregation and protection of assets previously in custody with prime brokers – and may eventually lead to a complete reorganisation of the relationships between prime brokers, custodian banks and hedge fund managers.
Panellists agreed that giving prime brokers custody of a portfolio of cash and securities, with full rights of re-hypothecation, is already giving way to a more nuanced model that makes greater use of third party custodians, tri-party arrangements, efficient collateral management , internal asset segregation tools and tighter documentation to protect assets.
The full content of the webinar, which was filmed and recorded, will be published at www.cooconnect.com shortly. Key points raised during the discussion included:
1) Drivers of prime custody services: The crisis exposed such major flaws in the traditional prime brokerage model that both managers and investors are seeking far-reaching changes, whereby unencumbered assets are held in an environment which insulates them from any risk of being caught up in the liquidation of a prime broker. Managers are as concerned as investors, panellists agreed, although the increasingly onerous nature of operational due diligence meant investors were often seen by third parties to be driving the process.
2) Initial varieties of prime custody unused: The initial reaction of prime brokers to the pressure was to develop trust bank or bankruptcy remote models within their own organisation, but panellists agreed these were little used because they did not provide a convincing alternative to the existing system, being largely reliant on an untested legal opinion (in much the same way, noted the panel, as cash collateral accounts at European CCPs appear to be developing) and threatening awkward operational complexities and asset retrieval challenges were the parent company to default. Hence a preference for third party custodian banks to look after unencumbered assets, and tri-party arrangements for encumbered asserts rather than conventional prime brokerage accounts.
3) No ifs and buts custody: Fund manager panellists made clear their preference for a simple custody service in which no lien or charge was placed over assets in custody (such liens are a standard feature of custody agreements, despite the custodian role being a purely fiduciary one) to avert the risk of their assets being trapped in prolonged liquidation, as happened in the Lehman case. Panellists reported that sub-custody risk was recognised, but global custodians were adamant they would not indemnify clients against loss at that level, or indeed losses occasioned by the local market infrastructure, such as payments systems or CSDs. Global custodians are concerned that the European AIFM Directive already turns them into insurers-of-last-resort, and that the UCITS V directive will extend that risk to regulated mutual funds.
4) Paying the price for segregation and safety: Views on the panel differed on whether an increased appetite for placing assets with third parties implied higher costs, in terms of explicit custody fees and implicit increases in the cost of financing, or just a redistribution of revenue between prime brokers, custodians and (possibly) utilities such as CCPs. Panellists reckoned regulatory pressure for matching of prime broker assets and liabilities, and increased liquidity and capital allocations, would have a larger effect on the cost of operating a hedge fund than any changes driven by prime custody arrangements alone. One panellist argued that he would be comfortable to see custody prices rising, if the service achieved his goals. Another said the cost of tri-party arrangements was tolerable, and worth paying: he put it at between three and five basis points. Panellists said the increased costs had not yet reached the stage where they were having to re-set investor expectations about returns.
5) The likely future shape of prime brokerage and custody: Panellists agreed future arrangements between prime brokers, custodians and fund managers would be highly variegated, and depend on size and strategy. Equity funds, for example, were much less suited to tri-party arrangements, because cash providers are less comfortable lending against equity collateral than fixed income collateral. It was agreed that prime brokers would be forced by the retreat of customer assets available for re-hypothecation and the rising proportion of long term debt and equity capital on the liability side of their balance sheets to curb maturity transformation and offer more term finance at higher prices. There was an expectation that global custodian banks, much of whose assets are funded by customer cash deposits, would look favourably on lending directly to hedge funds against the good quality collateral in their portfolios – though custodians are understandably reluctant to endorse this idea too openly, for fear of damaging their relationships with the prime brokers. Panellists also agreed that investment banks have skills which custodian could never reproduce, and that it would be hard to abstract financing and stock loan, for example, from research and execution.
A full sound recording of the webinar will be available at www.cooconnect.com later this week, and an edited, filmed version next week. A fuller write-up of the event will be included in the Autumn issue of COO, our magazine for members of COOConnect.
Moderated by COOConnect founder Dominic Hobson, the panellists were David Fletcher, chairman of Odey Asset Management; Malcolm Butler, partner and COO at Comac Capital; Marina Lewin, global head of sales and client relationship management at BNY Mellon AIS; Ashley Wilson, managing director and global head of equity finance and head of prime services at Barclays Capital; and Kumar Panja, executive director and head of the prime brokerage consulting group for EMEA at J.P. Morgan.