2
I
Prime Custody: Achieving Asset Protection & Operational Simplicity
Having an ability to “manage” excess securities to assure better
asset protections has changed the dynamics of how prime
brokers work with their hedge fund and investment manager
clients in the period since 2008. To the extent possible, these
clients are now looking to reassure their underlying investors
about the disposition of the hedge fund’s assets by having an
option to move unencumbered collateral out of their prime
broker’s control and into custody arrangements. This practice
has become known as “prime custody”.
Unanticipated collateral losses in the wake of the 2008
Lehman Brothers bankruptcy drew industry attention to legal
entity and counterparty risks inherent in the traditional prime
brokerage model. Interest in minimizing these risks sparked
the initial wave of prime custody offerings. Since that time,
offering this type of protection has become a standard part of
the prime broker service suite.
Hedge funds and investment managers look to these prime
custody arrangements during periods of market stress. This
helps them reassure their core investors that they are doing
their utmost to ensure the security of the fund’s underlying
assets. Prime custody is seen as especially important to
those hedge funds and investment managers with underlying
investors drawn from the institutional arena (pension funds,
sovereign wealth funds, foundations and endowments).
These institutional investors have come to represent the
majority of hedge fund industry’s assets under management.
Institutional investors are well acquainted with traditional
custody arrangements used in their core long-only portfolios.
Although the underlying ownership of assets differs in the
prime custody model, institutional investors have more
confdence in hedge funds and investment managers
set up to use prime custody arrangements when market
conditions warrant.
Distinct models for achieving segregation through prime
custody have been put forward by various prime brokers. As
these models have rolled out, there have been three points of
concern. Specifcally, how does the hedge fund or 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.
Two of the three models put forward by prime brokers fall
short on one or more of these measures. Citi Prime Custody
offers an approach that allows for all three concerns to be
adequately addressed.
Executive Summary
Hedge funds secure their fnancing loans by offering up long securities to their prime brokers as collateral.
Often, there are excess securities in these client accounts beyond those needed to meet their prime broker’s
daily margin requirements. Prior to 2008, those assets would remain in the prime brokerage account where
they could potentially be ‘re-hypothecated” via the prime broker’s securities lending desks.