In a new opinion piece, BNY Mellon CEO of Alternative and Broker-Dealer Services Brian Ruane argues that recent industry and 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.
The paper, ‘Filling the Void: Transparency and the Rise of Custodian Banks,’ was presented to more than 150 client and industry attendees at recent events in Dublin and London. In it, Ruane writes that due to stricter regulations following the credit crisis – from Dodd-Frank to the AIFM Directive – alternative fund managers are being compelled to reevaluate the right balance between counterparty exposure and a higher degree of safety. Ruane says this is creating distinct operating models for hedge funds in the U.S. and Europe.
Following the crash in 2008, U.S.-based hedge funds sought out custodians to safe-keep and service their unencumbered cash and securities. Through a custodian bank, hedge funds had the assurance not only that their un-invested cash balances were 100% FDIC insured through 2012, but also that securities would be kept off the custodian’s balance sheet and assets couldn’t 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 is the evolving European interpretation of prime custody. In Europe, hedge funds primarily use custodian banks to provide collateral management services on initial and variation margin. But European-based hedge funds are increasingly showing interest in custody services for their unencumbered assets as well. Driven by the need for greater asset protection and control, hedge funds in Europe are pushing prime brokers toward service models similar to those found in the U.S.
“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 U.S. 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 U.S., 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.