Recent economic events will see custody banks continue to play a larger role providing services to hedge funds that previously were the sole domain of prime brokers, according to BNY Mellon CEO of Alternative and Broker-Dealer Services Brian Ruane.
In an opinion piece titled Filling the Void: Transparency and the Rise of Custodian Banks, Ruane writes that stricter regulations – from Dodd-Frank to the AIFM Directive are seeing the creation of distinct operating models for hedge funds in the US and Europe as alternative fund managers focus on getting the right balance between counterparty exposure and a higher degree of safety.
The first model is rooted in the years following the 2008 crash, when US-based hedge funds sought out custodian banks to provide the assurance that their un-invested cash balances were 100% FDIC insured through 2012. Securities would also be kept off the custodians balance sheet and the assets couldnt be rehypothecated. Services traditionally reserved for prime brokers, such as clearing, cash and collateral management, became components of a service partnership between primes and custodians.
The second model deals with the evolving interpretation of prime custody, whereby hedge funds in Europe are pushing prime brokers toward service models similar to those found in the US to address the need for greater protection and control. These hedge funds are increasingly showing interest in custody services for their unencumbered assets in addition to traditionally using these custody banks to provide collateral management services on initial and variation margin.
The universe of companies providing key services to hedge funds has shifted dramatically. Hedge funds have gained a new appreciation for counterparty risk and financial strength and started to look at another group of service providers – custodian banks, said Ruane. Alternative investment managers in the US and Europe, as well as the more institutionally focused managers in Asia, are looking to custody banks as financial intermediaries who can deliver a seamless offering.
Ruane says the two models are evolving to meet the demand for asset protection through improved transparency. In the US, several prime brokers have created partnerships with custodians. These partnerships enable prime brokers to maintain their current relationship with their hedge funds, while offering the fund the ability to hold assets with a third-party custodian. Interest is expanding to European shores as well.
(JDC)