While many things changed in the wake of the economic turmoil of late 2008, one of the most profound shifts has been an increased focus from both investors and fund managers on striking a better balance between achieving non-correlated returns through alternative strategies and protecting assets held by hedge funds and alpha-focused investment managers.
Ensuring such balance had already been emerging as a point of concern prior to the financial industry crisis. Whereas institutional investors were able to segregate and exert direct control over assets purchased with funds allocated to long-only, beta-focused managers via their custodial relationships, they had far less visibility and control over assets purchased with funds allocated to alternative, alpha-seeking investment managers.
To secure the leverage required in many alpha-seeking strategies, hedge funds and investment managers forged strong relationships with Prime Brokers. To secure their financing loans and maximise their access to investable cash, hedge funds and alpha-seeking investment managers offer up long securities to their Prime Brokers as collateral. There would often be excess securities beyond the prime broker’s requirements. While this was not seen as a point of concern prior to 2008, unanticipated collateral losses in late 2008 due to broker dealer turmoil raised fears about counterparty concentrations and encouraged industry participants across the spectrum to look for a better approach.
Since that time, a new paradigm has emerged around better ensuring asset protection for alpha-seeking strategies by moving excess assets out of Prime Brokerage accounts and into segregated custody accounts. This practice has come to be known as “Prime Custody”.
Distinct models for achieving this segregation have been put forward by various prime brokers. As these models have rolled out, there have been three points of concern. Specifically, how does the hedge fund or alpha-seeking investment manager 1) ensure the right level of bankruptcy protection; 2) maintain an adequate geographic reach to support global portfolios for assets moved to custody and 3) reduce the operational friction of having both a prime brokerage and custody account with different entities.
The concentration of institutional money with hedge funds pursuing alpha strategies had two critical impacts. Direct institutional allocations to hedge funds resulted in a bifurcation of invested asset pools. Securities purchased with allocations to long-only managers were allocated back to investors and placed into segregated accounts held with global custodians. Securities purchased with allocations to alternative investment managers were posted as collateral against financing loans and held with prime brokers.
This split became exacerbated by the other knock on effect of institutional money shifting into alpha strategies. Many long-only fund complexes began to diversify in an attempt to protect their institutional allocations and they added alpha-focused strategies to their menu of fund choices.
From an investor’s perspective, the trade-off of seeking non-correlated returns through allocations to alpha-seeking strategies was thus a split in the location of their invested collateral across both custodians and prime brokers.
Historically, an investor had little direct exposure to a broker-dealer. Long-only fund managers would allocate positions they purchased from broker-dealers directly to the investor and the investor would instruct the broker-dealer to deliver their securities to a designated custodian.
Once securities were successfully delivered and settled in an investor’s custody account, there was no longer any exposure between the investor and the broker-dealer. The relationship was directly between the investor and the custodian up until such time that the long-only manager chose to liquidate .
Prime brokered assets are treated very differently. Prime brokers focus on extending their client’s buying power through financing loans made to facilitate leverage and secured by the clients’ long positions. Assets purchased by the hedge fund or investment manager are not allocated to individual investors, but are rather pooled by fund and assigned to the prime broker as collateral.
While the direct relationship is between the prime broker and the investment manager, the investor ends up having an indirect exposure to the prime broker and its broker-dealer entity since the assets that were purchased with their funds remain within the broker-dealer entity.
The downfall of investors having indirect exposure to broker-dealers with whom their alternative investment managers maintained prime brokerage relationships became abundantly clear in the Fall of 2008 as turmoil rocked the broker-dealer community.
Counterparty concerns increased sharply and in some instances, investors were unable to recoup collateral assets that were caught up in bankruptcy proceedings.
To protect their remaining investor allocations, hedge funds and alpha-seeking investment managers began to actively demand that their prime brokers provide an option to shift any assets not directly being utilized to support margin indebtedness or cover short selling into a segregated account.
By mid-2009, stabilization of the investment landscape, a rebound in market performance and impracticalities of the segregation model offered by early entrants became apparent. Hedge funds, alpha-seeking investment managers and investors all began to rethink their requirements and seek a more operationally-viable solution.
Early Prime Custody offerings followed one of two basic models. In one approach, a special purpose vehicle or trust was set-up as a distinct legal entity from the broker-dealer and excess assets could be moved out of prime broker accounts and into these arrangements. This model allowed for funds to continue to monitor and manage both their prime broker and custody accounts through their existing service relationship and allowed for an effective and easy exchange of data and reporting across the two accounts.
Feedback on the approach raised some concerns, however. Assets remained on the same broker-dealer infrastructure, eliciting questions as to whether the assets were remote enough in case of a bankruptcy.
A second model moved securities completely out of the broker-dealer entity and off the broker-dealer infrastructure , shifting excess assets to third party custodians. This arrangement was perceived as offering greater bankruptcy protections, but feedback from market participants highlighted fairly substantial concerns about the increased operational complexity of having to work across un-related entities.
Rather than having to create a brand new special purpose vehicle or employ a remote third party, we were able to combine capabilities across two-established and internal market-leading businesses. Prime Custody is a joint venture offered by Citi Prime Finance and by Citi Securities and Fund Services.
Since Citi Prime Finance is part of the broker dealer entity and Citi Securities and Fund Services is part of a separate custodial banking entity, clients are able to:
- Move assets off the broker-dealer legal entity and onto a bank legal entity to ensure bankruptcy protections
- Physically shift assets from the broker dealer’s to the custodian’s infrastructure for additional security
- Benefit from a normalized data model and systematic data exchanges between their custody and prime brokerage accounts.
- Examine their holdings and buying power across their custody and prime brokerage accounts from a single reporting platform.
- Instruct and monitor movements between their custody and prime brokerage accounts from their existing tools
Citi’s Prime Custody offering also exceeds the geographic reach of any competitor in this space. A final aspect of Citi’s offering is the provision of a smart algorithm. This algorithm was designed to make our Prime Custody offering risk and financing optimized to help our clients get the leverage they need at the most efficient price point.
Our smart asset selection algorithms take into account the outstanding margin requirement on the Prime Finance account and figures out what excess exists across both the Prime Finance and the Custody asset pools.
In addition to assessing the financing potential of assets, our Prime Custody offering recognizes that a asset servicing event is forthcoming and automatically sweeps back that asset from the Custody account so that the hedge fund or alpha-seeking investment manager can take full advantage of the Prime Broker’s longer declaration window.
No comments yet