In the wake of the collapse of two major banks - Lehman Brothers and Bear Stearns - global custodian banks are persuading increasingly wary hedge fund managers to consider placing some of their assets into their relatively safe hands, rather than risk placing everything with prime brokers. Writer Frances Maguire

Custodian banks may not have the large balance sheets or lending facilities that the prime brokerages have traditionally boasted, but since the disastrous demise of Bear Stearns and Lehman Brothers, major custodians are rapidly broadening their services to the increasingly risk-conscious hedge-fund community and are beginning to take a foothold among this lucrative client-base.

 For many hedge funds, the collapse of Lehman Brothers represented more than a loss of leverage: in some instances, the bank's collapse threatened to take with it the assets the fund had pledged as collateral against that leverage. In the current climate, in which counterparty credit risk is king, many hedge funds are re-evaluating with whom they hold their assets, and how those assets are divided up.

Flight to quality

 Patrick Colle, head of BNP Paribas Securities Services in the UK, says that the current climate has created a flight to quality. As a result, a chunk of activity, traditionally the preserve of the prime brokerage business, is moving away from prime brokers into the safer hands of global custodian banks.

 "There is a trend towards splitting the assets, whether in cash or securities, and placing the longer, unencumbered holdings into the custodians," says Mr Colle. BNPP has seen new hedge fund accounts as a result, he adds.

 This has prompted some custodians to begin building out prime brokerage services. Last month, for example, HSBC announced that it plans to add services such as foreign exchange and treasury products to its hedge fund clients in a bid to attract them away from prime brokers.

 Mr Colle believes the relationship between the fund managers and prime brokers is in the process of being re-engineered as hedge funds try to find the best tri-partite relationship between their prime brokers and a new global custodian.

 "Often we are seeing that the prime broker keeps some of the business as there is so much infrastructure already in place. Moving forward, we see the role of the prime broker remaining as the principle provider of financing, risk management and trading services to hedge funds," he says.

 There will be a distinct future split, however, between the long-only assets, and those areas of the business that must pledge collateral for leverage, other financing, or borrowing securities. As such, adds Mr Colle, a tri-party relationship, between the hedge fund, prime broker and custodian, will likely become a permanent feature of the future hedge fund landscape.

 Nadine Chakar, executive vice-president and head of Europe, Middle East and Africa at BNY Mellon Asset Servicing, says the bank is also benefiting from the recent flight to quality and flight to strength. Part of this new client activity is accounted for by a surge in interest from hedge funds looking to expand their relationship with the custodian.

 Historically, says Ms Chakar, BNY Mellon has offered every service to hedge funds, excluding financing. But in recent months, the bank's middle office has undergone further product development, particularly around derivatives, in order to improve straight-through processing and automation, and to establish more standards. In this regard, she explains, the custodian has been "helping our clients to better understand their collateral management, pricing and valuation needs, which were typically areas that were handled by their prime brokers".

 The attraction of a one-stop service, as well as the greater flexibility in terms of rules and regulations, put the prime brokers ahead when it came to fully servicing hedge fund client needs. However, the custodial giants are becoming a lot more nimble and are adapting to the new realities: evidently, they are now targeting the hedge fund business.

 "We have focused hard on reinventing ourselves, on being more nimble and more responsive, to be a step ahead of the market to give our clients more services and more choice," says Ms Chakar.

 Rajen Shah, head of global custody at JPMorgan Worldwide Securities Services (JPM WSS), says that hedge funds are moving into more regulated funds due to investor apprehension, and this is resulting in the shift back to traditional custodians, along with the move towards more long-only funds.

 Following its acquisition of Bear Stearns in March last year, JPM WSS is now able to offer its clients the best of both the custodial and prime brokerage worlds.

 "We have, via our acquisition of Bear Stearns last year, an integrated prime broker product, which allows the hedge funds to keep their short positions with their prime broker, keep their long positions at the custodian, but have an integrated service for moving collateral between the two and for consolidated reporting," says Mr Shah.

 "Servicing hedge funds is about integration between a prime broker and a custodian," he adds.

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Rajen Shah, head of global custody at JPMorgan Worldwide Securities Services (JPM WSS) Heightened interest

 While recent events in the market have not prompted JPM WSS to change its model, there is heightened interest from clients in outsourcing non-core processes because of the downturn. In response to growing demand for more services, especially around risk management, performance monitoring and compliance, JPM WSS has enhanced its services to offer tax-transparent pooling or long/short capabilities to traditional asset managers as they increasingly move into hedge fund-like strategies.

 Where there is complexity, as in structured products, Mr Shah believes there will be more contained growth while traditional products will continue to flourish.

 "There will be a sea-change around how the market operates and around increased governance, increased regulation, and the need for more transparency around products deemed to be more complex," he says.

 For these reasons, Mr Shah believes there will be little growth in 2009 until the end of the year. But when the signs of growth return, these will be found around more traditional products, as well as around outsourcing of more non-core middle and back-office-functions.

 Jeff Holland, partner at Brown Brothers Harriman (BBH), says that the economic downturn, the collapse of Lehman Brothers and the Bernard Madoff scandal - in which the former Wall Street celebrity was convicted of defrauding investors through a Ponzi scheme - have led clients to reconsider things that they used to take for granted, even where custody services are concerned.

 "They are now recognising that there is some value in independence. Often it was seen as efficient to lodge funds with the prime broker but today there is a realisation of the risks of not having diversity and independence."

 Mr Holland also says that a small minority of fund managers are looking at consolidating the number of custodians they deal with to achieve further efficiency and cost savings from their business, but for the majority, diversity remains important.

 "There are risks in trying to achieve such economies of scale, so we try to give clients the means to achieve efficiency and economies of scale, without the risks," he adds.

 BBH's own network strategy is a multi non-captive strategy and Mr Holland believes the more diverse approach does not come at a greater cost but helps provide competition, in terms of price, quality, service, as well as the advantage of more than one market information source and having an automatic alternative for contingencies.

 "We are well versed at dealing with a multi-prime, multi-sub-custodian environment, and we have seen clients subscribing to this whereas before bigger, or simpler, was better. Clients are questioning what they were doing in the past, and we are seeing clients leaving increased cash with us as they see us as a safe haven," he says.

 BBH chose not to go into the hedge fund administration business originally because the custodian did not like its risk/rewards metrics, particularly as the prime broker traditionally held all the fund's assets. But while BBH is not changing its model, it now sees multi-prime clients as more attractive and is providing those capabilities for select clients - holding long-only assets and managing collateral on behalf of clients.

 "We believe these services are in the spirit of what a custodian should be there for as opposed to the models in the past when the administrator or the prime broker held the assets. Clients are thinking differently now," says Mr Holland.

 Mitigating risk, reducing cost, streamlining operations to eliminate inefficiency and enhancing performance are still the key factors that BBH is focusing on for its clients, together with gathering additional assets from fund and asset managers and non-US financial institutions, and developing new products.

 One such service is BBH's provision of firms' entire Swift communications infrastructure. Another is BBH Direct, which enables domestic and regional custodians to offer BBH's custody services on a white-labelled basis. BBH has also developed a range of fund solutions to connect the distributors and manufacturers of funds to the underlying investor. This service forms part of BBH's global service model for international clients with a global client base.

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Jeff Holland, partner at Brown Brothers Harriman (BBH) Middle office

 However, it is in the middle office where BBH is taking large strides. Back in 2007, BBH was one of the first custodians to test contract notifications over SwiftNet using Financial products Markup Language (FpML), and has now introduced a solution for automating the transmission and processing of over-the-counter (OTC) swap transactions to enable straight-through processing (STP) for credit default swaps and interest rate swaps.

 According to BBH, the service, which is one of the first automated STP solutions for OTC instruments on the market, helps clients to manage the rapidly growing volumes of derivative transactions in order to decrease operational risk and accommodate both continuous growth and volume spikes.

Increased transparency

 BNY Mellon's Ms Chakar says derivatives servicing is emerging as an industry in its own right. BNY Mellon is aiming to provide a lot more transparency in this area.

 She says: "It is a three-pronged approach: operations; intellectual capital, an area where we have upgraded our capability over the years; and reporting, to enable our clients to have the know-how and transparency so they can engage in more transactions."

BNPP is developing cross-product solutions complementary to those of the prime broker, across asset and hedge fund managers, and using its local and global custody services, escrow agency and collateral management services. It is, for Mr Colle, part of a 'back-to-basics' development, not only back to custodian banks but back to the higher-rated custodian banks in particular.

 BNPP is also extending its relationships with existing clients to include cash management and foreign exchange business, most recently with Henderson Global Investors, as an expansion of its outsourcing services, which is growing as asset managers seek to consolidate acquisitions. In addition to providing investment operations services, and related banking services such as custody, securities lending, cash and foreign exchange, BNPP will also enhance its global distribution contribution to Henderson's products.

 "We are expanding the scope of our product offering to large UK fund managers but remaining focused as we want to be servicing the largest franchise names," says Mr Colle.

 "It is also important to us to take on board as many components as possible - where there is fund accounting or an investment manager's outsourcing business we make sure we also get the global custody piece with it and, if possible, the foreign exchange and securities lending, because this is a win-win combination for both BNPP and the client."

 Even without the traditional financing arrangements that have made the prime brokers so uniquely attractive to the hedge fund industry in recent years, there is evidently a lot of business for the custodians to go after.

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