Hedge fund assets in prime custody surges, says BNY Mellon/Finadium report
Hedge fund assets in prime custody have jumped by 40% to $684 billion since 2010, according to a study by BNY Mellon and Finadium.
Prime custody is proving attractive
Roughly half of all hedge funds managing more than $1 billion now have prime custody agreements in place, up from 15% in 2008. The study said growth in industry AuM, concerns over counterparty risk and lower levels of borrowing from prime brokers were the main drivers behind the increase.
Hedge funds’ reliance on prime brokers as a source of leverage has diminished in the last few years. The UK Financial Services Authority’s (FSA’s) latest hedge fund survey revealed collateralised borrowing from prime brokers had decreased from 24% in October 2009 to 14% in October 2011. Repo-ing of fully paid assets now accounts for 55% of leverage while total return swaps, contracts for differences and other leveraged products comprise 28% of leverage. The study said this change had made custodians an attractive alternative for hedge funds.
Investor and manager concerns about counterparty risk and safekeeping of assets in light of the Lehman default, and more recently MF Global, have also facilitated the move towards prime custody. “Investors were concerned that prime broker counterparties might default and freeze assets in the process. By keeping as many assets as possible in an unencumbered long-only account, this concern was thought to be mitigated,” read the report.
“Prime custody was ultimately borne out of the crisis,” said Malcolm Butler, partner at COMAC Capital, a London-based global macro hedge fund manager. “At COMAC we used Lehman as a fixed income prime broker and it became very obvious in 2008 that we had to change. It was clear we needed a fixed income prime broker but we had to dis-intermediate and opt for custody. The custody model gave us asset protection and moved us away from Lehman. Custody is a very good alternative for managers,” he added.
Fears over rehypothecation have also made prime custody an attractive option. “They (hedge funds) have no concerns about assets being rehypothecated as all funds are in long-only, no margin accounts,” read the report.
However, a growing number of commentators are questioning how safe the custody model actually is. Some speculate that were a custodian to default, managers and investors would still struggle to access their assets. “I am concerned that were there a massive fraud or if the custodian goes down, it would be hard to find assets. While I love the custodian model, it is essential they prove what they would do with the assets in an administration. Would it take time to negotiate my assets back with the administrator? Once you get paranoid about these things you stay paranoid,” commented David Fletcher, chairman at Odey Asset Management.
Some managers, said the paper, also expressed concerns about the legal arrangements whereby prime brokers controlled the custodial account as it meant “the prime broker could recall those assets in times of need.”
The paper also revealed there were regional differences in hedge fund attitudes towards prime custody. “In Europe, hedge funds have always had third party administrators operating in the background alongside prime brokers and this has reduced the operational burden of funds in adding on a prime custody service. At the same time, the Lehman collapse and concerns over a repeat of a Madoff-type of scandal have shown the importance of managing commingled and custodian long-only accounts on a proactive basis,” read the report.
Asian managers, on the other hand, have been late to take on prime custody although their interest is clearly on the up. “During the second quarter of 2011, three new factors changed market behaviour. First, hedge funds appeared to only gain the appropriate scale with some new funds launching with $500 million to $1 billion. Second, institutional investors began to strongly request that their hedge fund managers open prime custody accounts. Lastly, funds became concerned yet again about the counterparty risk of their prime brokers,” read the report. Several firms have taken note of these changes in Asia. HSBC, for one, launched a prime custody model in Hong Kong in 2011, which was based on its European offering.