COO COO | peer group network | www.cooconnect.com | issue no. 1 | winter 2011
COO Q&A
Prime Custodian One lasting impact of the collapse of Lehman Brothers is that hedge fund investors want to know that their assets are safe and visible. Capital allocations are now sometimes dependent on the appointment of a third party custodian. This has had a massive impact on the economics of the prime brokerage industry, in which managers traditionally gave investment banks complete control of the assets of a fund in return for stock loan and financing. But it has also forced custodian banks used to dealing with slower-moving and infrastructurally better-equipped traditional fund managers to change their ‘modus operandi’ too. The bank that has adapted most successfully is BNY Mellon, which did not take long to work out that it was already providing most of the services hedge funds wanted—ironically, to broker-dealers. COO asked Marina Lewin, head of global sales at BNY Mellon AIS, what had to change and what did not have to change. What are hedge funds placing in custody with you? Unencumbered securities and cash. Though the initial focus was on securities, hedge funds have also taken to placing cash with us, because they find we are a convenient and competitive place to hold cash awaiting reinvestment or redemption calls, or which is being 2
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pledged as collateral to swap counterparties. They like the fact that we can hold the cash offshore as well as onshore. In all, we have around
COO Q&A
US$140 billion in hedge fund assets in custody, which we reckon gives us a share of around 20 per cent of the market for prime custody services. Talking of cash, it was recently disclosed that BNY Mellon had become such a popular destination for cash that the bank was having to charge a negative rate of interest. What is the background to that? We offer a mixture of deposit accounts and money market funds, including some managed by third parties. Interest rates remain at exceptionally low levels and the Fed has indicated that they are now likely to remain low through to 2013. In this environment, we could not support unlimited amounts of cash on which we could not earn a return. However, it should be noted that we have not charged any clients to date and the policy remains in place as markets remain unsettled and interest rates remain at historic lows. The deposit fee would potentially affect a small number of institutional clients with extraordinarily high and volatile deposit levels. The fee was never designed as a revenue source, but only to cover our additional costs in unusual situations.
How does your prime custody product compare with the trust company or bankruptcy-remote offerings developed by prime brokers? With our model, if there was to be a trigger event at the prime broker, the hedge fund client would be protected from the counterparty risk some funds experienced in 2008. Their assets are held in segregated accounts at BNY Mellon as a fully independent third party custodian. Some primes offer special purpose vehicles as an alternative, but these are untested and rely on a legal opinion which may not count for much in a crisis. So many hedge funds have opted to hold their unencumbered assets completely outside their prime and not in a separate structure within the prime or another unit of the prime. Importantly, assets that are held in custody with us can still be leveraged for other purposes, such as tri-party financing arrangements, in which we continue to hold the assets pledged to the lender. Hedge funds are not like traditional fund managers—they want everything done yesterday and reported now. How difficult has it been for BNY Mellon to adapt to their demands? Within AIS, we offer a higher touch service model and are no Reprinted from 1st issue of COO
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COO Q&A
longer considered just a pure custodian. We have built a strong customer service environment for our managers and invested significantly in its development to ensure our services match the evolving requirements of our clients. It is true that most hedge funds do not have the operational infrastructure that a large pension fund or mutual fund might have, so their requirements of us are bound to be different. Every hedge fund strategy is also different and we have to cater for that too. Can you give us an example of how you service hedge funds differently from traditional managers? For certain strategies, the trade matching and reconciliation services we offer differ hugely from the services we offer as a traditional custodian. We have invested a lot in our technology, to change how we take receipt of trade files, for example. That has enabled us to enhance our service model to ensure we are responsive to the needs of hedge fund managers by offering faster reconciliations with brokers and pre-matching of trades to minimise the risk of failure. You can provide a lot more than custody, cash management and trade 4
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settlement. What else are hedge funds buying from BNY Mellon? We can offer asset-servicing as well, including corporate actions. In addition, we have an integrated and seamless connection to our fund administration services, which enables us to be a full-service provider to all of our clients. Funds that did not use us as an administrator can now use us as a prime custodian and prime custodian clients are now using us as an administrator. Are there synergies between prime custody and fund administration? Asset valuations are an obvious one: we value the securities they hold for investment and trading purposes, as well as safekeep them. We also send monthly valuation statements to the investors, which are after all the people driving assets into prime custody. At the end of the year, the administrator also provides financial statements to the auditors to the fund, so we play an important role in corporate governance. Some hedge funds that have not previously used a third party administrator— including some closed funds that do not need to worry about third party investors—have appointed us to provide a so-called ‘NAV-lite’ service, which we call AV/PV, or asset validation/price verification.
COO Q&A
But many new investors are now demanding third party custody and fund administration as the price of investing and it is operationally convenient as well as better value to combine the two. BNY Mellon has tri-party securities financing and stock loan services that it has traditionally offered to brokerdealers only. Are you now offering them directly to hedge funds? Some hedge funds have the willingness and capability to self-finance and are happy to use us as an agent, particularly to post collateral to lenders. We are not willing to act as principal to financing transactions with hedge funds. The more complicated financings tend to remain with the prime brokers anyway. That said, we have formed partnerships with a number of prime brokers, including Deutsche Bank and Goldman Sachs [see separate story, page 76, who continue to provide margin finance against assets in tri-party accounts with us, or against collateral moved to their accounts by us from a custody account with us. Are you competing, in effect, with prime brokers? No. We are partnering with them. We have established partnerships
with several large prime brokers to provide hedge funds with the ability to hold their unencumbered assets with BNY Mellon, while continuing to fund and lend those assets through their prime brokerage relationships. Through our platform, hedge funds can seamlessly move their positions to and from their custody accounts to satisfy their activity within their prime brokerage accounts, while benefiting from the diversification of counterparty risk. Hedge funds are used to posting collateral for repo and margin finance, but centralised clearing will now force them to post initial and variation margin to CCPs as well. Does it make commercial sense—in terms of fees, but also in terms of your relationships with prime brokers as clearing brokers to CCPs—to offer third party collateral management services to hedge funds? Managers have become more sophisticated and institutionalised and many now use a core custody account to feed collateral accounts that enable them to pledge assets to third parties. It is not a great operational challenge for us because prime custody is a lot like collateral management, in the sense that we move assets between a custody Reprinted from 1st issue of COO
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account at BNY Mellon and a brokerage account at the prime broker. We are judged by the ease and efficiency with which we do that. Managing collateral across financing and swaps means going a step further and at present we offer that to the largest managers only, because they tend to control their own funding. They use tri-party arrangements between themselves, us and the prime broker. In the derivatives markets, both OTC and exchange-traded, our broker-dealer services group is offering an initial and variation margin management service, in which we will post assets in prime custody with us to the CCPs, or to the prime broker as counter-party to non-clearable swaps. Are you lending stock directly to hedge funds as well? Hedge funds tend to be borrowers and some have asked us if we would be prepared to lend stock. For now, we prepare to leave that business with the prime brokers, because our lending clients are not always comfortable with the credit risk. Some hedge funds already use us to lend their assets. Inevitably, servicing hedge funds has blurred the division of labour 6
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between BNY Mellon and your prime brokerage clients. How awkward has that been? The division of labour is still intact, in the sense that the prime brokers are servicing the asset side of the hedge fund industry, while we are servicing the liability side. If hedge funds want classic prime brokerage products, they can obtain them from our prime broker subsidiary, Pershing. But we do increasingly partner with prime brokers, who are of course also clients of BNY Mellon in our brokerdealer clearing and tri-party financing business. The partnerships take the form of tri-party arrangements, in which we hold collateral posted against financing or swap transactions between hedge funds and prime brokers. The prime brokers would rather hold the collateral themselves but hedge funds—and especially their investors—are not always comfortable with that any more. Prime brokers are familiar with tri-party and know that we offer the product on standard terms, so no prime broker is getting preferential treatment. How happy are you with the development of your prime custody services? The custody business we do with hedge funds is six times larger than
COO Q&A
it was four years ago. We now have business relationships with most of the top 100 hedge fund managers. We are running one of the fastest growing businesses at the bank. So, yes, we are very happy about the development of the business. Much of the business has of course come to us because alternative investment managers wanted to diversify and move away from their traditional prime brokerage relationships, but we have also had to build a service model that fits their needs. Hedge fund managers need an enhanced service model that includes high touch customer service, research, reconciliation, corporate action processing and a robust core custody service capability. Do you ever see hedge funds reverting to the ‘status quo ante’ the crisis, in which they used their prime brokers as custodians? No. We believe the shift that hedge funds made to a multi-prime/ custodian model after the events in 2008 will remain in place. As hedge funds continue to be pressurised by their investors and by regulators to be more transparent, establishing a custodial relationship in addition to their primes enables them to accomplish both greater safety and increased transparency.
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