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Hedge Funds And Global Custodians: Not Such Unlikely Bedfellows

We are in challenging times for hedge funds. Having performed well during the financial crisis, they have lagged over the last seven years and alternative asset levels have been eclipsed by rapid growth at the passive end of the management spectrum.

A new world emerged from the financial crisis. Led by investors and aided by their risk and compliance managers (who would have brought a CCO to an investor pitch in 2007?), the focus has shifted clearly and deliberately to more stable returns and more transparent governance. Hedge funds are paying attention to liquidity, safety, stability and, of course, regulation. The hedge funds that survive and intend to thrive are forging new partnerships and developing new operating models to address the new reality.

The financial crisis was followed by an inevitable avalanche of regulation. The hedge fund prime broker model has changed almost beyond recognition. Rehypothecation – the practice by counterparties of reusing client assets posted as collateral – became unpopular as investors were chilled by the very real possibility of evaporating capital. Yield has steadily declined as governments sought to prop up the global economy.

New partnerships

Today, hedge funds are forging partnerships with global custodians, not as a replacement for the prime brokerage model that had served them so well but as a complement to it. In doing so, they are finding new opportunities to enhance their offerings. The global custody business is one that has safety, stability and transparency encoded in its DNA and is proving that it can be every bit as dynamic and flexible as the prime brokers. On the whole, global custodians remain focused on maintaining the safety of their capital bases, which aligns exceptionally well with the interests of hedge fund managers and their institutional investors. This capital base gives confidence and commitment, something that hedge funds can lean on and build from.

Highly specialised, alternative managers live with a dynamism that is unmatched in the traditional long-only investing world. They bring innovation and knowledge, but rarely do they have much interest in building out extensive back office functions. Consequently, global custodians are proving themselves capable service providers, enabling hedge fund managers to enhance their operational performance and keep investors satisfied.

Security and governance

The custody world is learning fast. They understand what makes hedge fund managers tick but they also do one thing extremely well: holding and maintaining assets. They have the systems, the governance and the controls to make sure assets are safe and exactly where they should be at all times, every day. Hedge fund managers need to be sure that when they enter into a trade, the asset will end up where it is supposed to be. Custodians manage that settlement risk very closely and ultimately allow the manager the freedom to trade without worrying about where the trade ends up.

The low yields persisting around the world have caused headaches for many portfolio managers. Custodians have led the charge in showing that just because assets need to be in safe custody does not mean they have to be dormant. Putting portfolio assets to work by lending them out, or using them as collateral for various tri-party transactions with the benefit of a stable credit-worthy global custodian in the middle has proven a welcome boost to yield.
 
This Prime Custody activity (for this is what we call it) even allows hedge funds to keep in touch with their old friends, the prime brokers, as custodians use their technological muscle to move assets around from collateral accounts to portfolio accounts and back again, facilitating access to leverage. Moreover, global custodians are now leading lights in the FinTech world, using new technology for everything from data mining to information delivery to artificial intelligence and blockchain.

Fostering innovation

Underlying that is a new culture of agility that delivers more transparency and fosters innovation. Hedge funds are demanding more insightful and timely data. The global custody world is responding by building an entire ecosystem that digitises systems and processes all geared toward assisting efficient decision-making.

It remains a challenging and changing world for hedge funds, but they are finding innovation and new levels of support through partnerships with custodians.

Scott Coey is Managing Director and Head of EMEA Relationship Development, Hedge Fund, ETF and Structured Products, at BNY Mellon. The views expressed herein are those of the author only and may not reflect the views of BNY Mellon. This does not constitute investment advice, or any other business, tax or legal advice, and should not be relied upon as such.