John Mack was wrong. Investment banks risked failure not Because of shorting, but because they were Using the assets of prime brokerage clients as if they were their own. Far from sinking the firm, shorting funded the firm. So what happens when those assets are elsewhere?

Prime brokerage was once described as the largest but least noticed banking system in the world. It worked like this: the prime broker gave the hedge fund manager the opportunity to trade with anybody they wanted and finance any position it adopted, while the hedge fund gave the prime broker everything its investors owned—long positions, short positions, cash—and allowed the prime broker to do more or less whatever it liked with them, including using them to fund the prime broker in the shape of cash collateral, poorly remunerated cash deposits, stock for loan against cash collateral and for collateral upgrade trades and the excess margin buffer (which could of course be altered at will by the prime broker). The credit risk incurred by the prime broker was not only collateralised but rewarded by some of the highest margins on Wall Street and in the City. The credit risk incurred by the hedge fund manager was not ignored, but it certainly remained non-negotiable. Then the crisis of 2007-08 happened and it turned out that the credit risk operated in the reverse of the anticipated direction.

When Bear Stearns began to crumble in 2007, investors told their hedge fund managers to move their cash and securities somewhere else. Multiple prime brokerage, initially favoured to limit information leakage, suddenly became the most popular form of counterparty credit risk management. With prime brokers unable from the summer of 2007 to fund themselves, let alone their hedge fund clients, the terms of the prime brokerage trade changed—though not necessarily in favour of the hedge fund, since prime brokers became more adept than

By the autumn of 2008 one thing was clear: assets were safer with a US broker-dealer than a UK bank. American prime brokers could fail, but as US broker-dealers their customers were not treated as general creditors. SEC Rule 15c3-3—the customer protection rule for broker-dealers— insisted fully paid-for and excess margin securities had to be segregated from assets pledged to or owned by the broker-dealer and any customer cash other than cash pledged as margin had to be locked up in special accounts accessible only by customers. This was why most US broker-dealers were parking unencumbered customer assets in segregated accounts at in-house trust companies long before the crisis broke.

So when a broker-dealer failed, as Lehman Brothers did, all customer cash and other assets were given preference over general creditors of the firm. Assets held at US broker-dealers also benefited from the additional protection afforded by the Securities Investor Protection Corporation (SIPC). In an SIPC liquidation, customer property was not caught up in a prolonged liquidation, but returned to customers.Any shortfall in the aggregate— which might easily occur in the case of securities pledged to the firm as collateral—was allocated pro rata among all customers, so a 10 per cent shortfall in the total value of customer assets resulted in a 10 per cent haircut for all customers. But the shortfall was covered by SIPC insurance of up to US$500,000 per customer, including up to US$100,000 of cash. None of this applied in London, where Lehman Brothers International operated under a much looser regulatory and insolvency law framework that has tied customer assets up for years in liquidation proceedings. It did not help that in a number of cases where Lehman Brothers International was contractually bound to segregate client assets in London, it had failed to do so.

Something had to change in hedge fund custody arrangements. An obvious alternative was to follow the example of the traditional investment management industry and appoint a creditworthy, third party bank with a large balance sheet to safe keep the cash and fully paid (or unencumbered) assets of the fund. In theory, a custodian bank—or what Americans still refer to as a trust bank—ostensibly held no customer assets on its balance sheet. In theory, trust or custody assets were entirely separate from the activities of the bank. The bank was purely an agent, not a principal. Each customer had securities in the digital records of the bank earmarked as their own. Unfortunately, practice is of course a lot fuzzier than that. Most securities are actually pooled in omnibus or nominee accounts in the name of the custodian or trust bank. Indemnities offered by custodians to encourage clients to do business with them have a habit of ensuring that client assets lent to broker-dealers end up on the balance sheet when something goes wrong.

Though customer cash is no longer held in ordinary deposit accounts of the bank as a matter of course—in-house and third party money market funds are made available as an alternative—it is entirely possible that client cash will be used to fund the bank. Customer cash could also end up in collateralised, off-balance sheet conduits or SIVs that were not formally indemnified by the bank. Losses in these vehicles are not always made good by the custodian banks (an honourable exception is State Street). Above all, custodians have long pursued a business model which is less than reassuring: the core custody product is virtually given away as a loss leader, in order to attract assets which can be exploited for profit through securities lending, fat spreads on cash deposits and even wider spreads on foreign exchange bargains. In other words, even the apparently dull and squeaky-clean custodian banks operate in a fashion not wholly dissimilar from prime brokers: they use the customers’ property to make money for themselves.

So what is a hedge fund manager to do? By late 2008 investors were demanding the assurance of third party custody. But assets cannot be financed if they are not in a prime brokerage account. So the hunt was on for hybrid solutions that kept unencumbered assets at a safe distance from flaky broker-dealers, while also keeping them at hand if they needed to be sold, lent or financed. The initial solution was an obvious one: move prime brokerage accounts from broker dealers to the prime brokerage arms of banks with big balance sheets (notably Credit Suisse and Deutsche Bank, but also BNP Paribas) and later to banks which might have problems of their own but which are deemed too big to fail (such as Citi and UBS). For the first time, hedge funds started taking a close interest in whether the counter-party named in the documentation was the parent company in Frankfurt or Paris or Zurich or the broker dealing subsidiary in New York, which the parent company might be free to abandon in a crisis. Cash flooded into creditworthy custodian banks with no serious prime brokerage capabilities at all, such as BNY Mellon, HSBC, J.P. Morgan and Clearstream, to the point where banks ran out of ideas about what to do with it (something similar occurred this summer, when BNY Mellon started charging a negative rate of interest).

Some larger hedge funds opened full custody accounts for the first time. The broker-dealers that survived the crisis of 2008— namely, Goldman Sachs and Morgan Stanley—even turned themselves into banks. They also developed in-house ring-fencing solutions to staunch the outflow of assets, mostly by re-naming or re-marketing or re-designing their existing trust company solutions, or adding something similar in Europe and Asia. “Post crisis, clients wanted to move unencumbered assets away from the broker dealer and wanted to use custodians to perform this service,” says Joe Davis, managing director of prime brokerage at Morgan Stanley in New York. “Clients wanted to diversify their risk.” It was in this febrile atmosphere that “prime custody” entered the lexicon of the hedge fund industry. It emerged as the prophylactic of choice among hedge fund managers looking to protect themselves against counterparty risk.

Three years on from the failure of Lehman Brothers, three principal models of prime custody for hedge funds have established themselves: the special purpose (or bankruptcy remote) model, the internal custody model and the external custody model. The first was really developed by Goldman Sachs (which re-named its trust company GS Bank USA and created Montagu Place as a bankruptcy remote entity in the UK) and Morgan Stanley (which in June 2009 re-launched its own trust company as a bank called Morgan Stanley Trust National Association).Both had suffered massive losses of prime brokerage balances in 2007- 09. But even Bear Stearns, which accidentally acquired the protection of J.P. Morgan six months before Lehman failed, morphed the custodial trust company it launched for a mutual fund client back in 1997 into the J.P. Morgan Clearing Corporation and began to promote it to edgy hedge fund clients. All three saw the new services as an answer to the principal challenge posed by the appointment of a third party custodian: the operational difficulty of moving assets between a prime brokerage account and a custody account at a third party bank (the hedge fund had to instruct a custodian to send or receive as well as a prime broker) and keeping track of them (through two different reporting systems whose data could not be united except by clumsy and infrequent file transfers).

Then there were the additional costs, which mounted quickly if a fund traded actively. “For actively traded portfolio securities, movements back and forth between a global custodian and a prime broker would have been expensive and have led to operational risk,” explains Davis. “Morgan Stanley used an existing national bank subsidiary to create a custody solution for unencumbered assets. Morgan Stanley’s custody product, which is separate from the broker dealer, provides clients’ assets with safety and soundness for their unencumbered assets. This product enables clients to move unencumbered assets to our bank subsidiary whenever they want and still have access to Morgan Stanley’s technology and service model.” Morgan Stanley has re-built its prime brokerage balances in the last two years, albeit not yet to former levels, but it is hard to believe that the Morgan Stanley Trust National Association played a big part in that process. Indeed, solutions of exactly that kind have come under critical scrutiny by the practitioners of the new profession of operational due diligence. Pierre Emmanuel Crama, head of operational due diligence at the London-based fund of hedge funds Signet Capital Management, says that bankruptcy remote vehicles are preferable to the traditional prime brokerage model, but they are completely untested in a crisis.

If a prime broker with a bankruptcy remote vehicle attached to it happens to default, there is no legal or practical precedent for determining whether investors whose unencumbered assets are held in such vehicles, will get them back. Of course, prime brokers offering bankruptcy-remote custody services have purchased expensive opinions from counsel attesting to their legal soundness, but hedge fund managers are cynical enough to remember that in the autumn of 2008 possession proved to be nine tenths of the law, especially when the survival of the prime broker was at stake. One prime broker thinks fund managers are right to be cautious. “Even if client assets are separate from the rest of the bank’s assets, if I was a manager, I would be asking when I could get access to and trade the assets” says Atilla Olesen, head of prime brokerage and securities finance UK, and co-head of SEB Enskilda Equities, in London. “During a period of market turmoil, managers need to trade. There must be people in the special purpose vehicle, adequate systems and clarity that the special purpose vehicle can continue arrangements and meet its obligations to the client. Given the UK’s bankruptcy laws, hedge fund managers are going to be doing a lot of due diligence on prime brokers offering these products to assess the likely scenarios in the event of a default.”

On that point, Joe Davis launches a barrage of assurances. “The prime broker has no claim on the assets in the trust vehicle” he stresses. “We went to UK and US counsels about the bankruptcy independence of the national bank subsidiary and its connection to the US/UK broker dealers. Both counsels issued Morgan Stanley with opinions stating in the event of a bankruptcy or insolvency proceeding at the custodian bank, broker-dealer or parent level, the client assets held in custody would not be treated as the assets of any Morgan Stanley entity. These assets would remain totally unencumbered and there would be no lien on them, so we would deliver them to our clients at their request.” Asked how Morgan Stanley staff would deliver anything if the firm was mired in bankruptcy proceedings—when Lehman failed, liquidators locked the London staff out of the building—Davis says there is no risk of history repeating itself. “We have addressed any operational risk posed by the setting up a secured space away from our facilities that could support the in the unlikely event of a business interruption at Morgan Stanley” he explains. “Custodian bank employees have access to the space which has dedicated and independent technology to allow for communication with our clients.

Morgan Stanley has spent significant sums of money ensuring that this system works and we test the facility on a quarterly basis.” The firm believes that this combination of safe custody (albeit one based on legal assurances rather than practical experience), off-site facilities and the operational and reporting advantages of a single prime brokerage platform is an adequate riposte to hedge fund managers sufficiently concerned about the counter-party credit risk of Morgan Stanley to consider appointing a third party custodian. But even if there are operational efficiencies, the service is not without cost. “It is extremely reasonably priced” argues Davis. “We have notdone this as a profit-making business. This was something we needed in our arsenal to ensure clients were comfortable with giving us their prime brokerage business.”Another prime broker, Deutsche Bank, has gone down a different path. It has since 2009 offered clients the option to place unencumbered assets with a third party custodian. Third party custody is now available at Deutsche Bank through BNY Mellon or Northern Trust, allowing counter-party diversification on the custody side while maintaining the benefits of prime brokerage services and reporting—though it does entail paying fees to BNY Mellon or Northern Trust as well as Deutsche Bank. While the initial launch focused on European clients, the model is also gaining traction in the United States. The operational burden of moving and reporting assets is borne by Deutsche Bank, but daily oversight and control is in the hands of the hedge fund manager. The German bank says it has invested heavily in the technology and consolidated reporting platform to ensure the movements are as uninterrupted and inexpensive as possible. “A lot of our clients are interested in this model” says Anthony Byrne, global head of securities lending and co-head of prime finance at Deutsche Bank in Hong Kong.

“Deutsche Bank provides a working model where all of the processes, including moving assets, servicing and reporting are highly automated and integrated, allowing the operational workflow for the manager to be largely unchanged. This is a value added proposition because clients can outsource the operational aspects of having prime brokers working in tandem with custodians—something that is an operational challenge and has acted as a disincentive to use this safer route in the past. We invested heavily in the technology, legal review, consulting and infrastructure to provide that protection and [asset] segregation. Everything we do is able to be consolidated and we allow movement of assets between the prime brokerage and custody accounts in a seamless fashion. Our model is the best of both worlds.” Deutsche Bank can of course offer company risk on assets in custody with Deutsche Bank Securities Inc. as prime broker, but allowing clients to opt for an uncompromised, independent custodian such as BNY Mellon or Northern Trust is a powerful sales pitch against the bankruptcy-remote alternative. “One of the challenges of the SPV models is that they have not been tested” says Byrne. “Furthermore, they are deficient in that the vehicles are by definition lowly capitalised, have far smaller infrastructures and staffing and may not be considered systemically important by regulators.”

Though Deutsche Bank sold its global custody business to State Street in 2003, it retains a sub-custody network spanning the world and can offer hedge funds an in-house custody service separate from its prime brokerage arm as well on a market by- market basis. That is attractive, in the sense that it replaces Deutsche Bank Securities Inc. counterparty risk with Deutsche Bank AG counterparty risk. But the German bank reckons fund managers and their investors are bound to be less comfortable with any solution that offers asset segregation within the same banking group. “If a client is concerned about the viability of a financial institution, they tell us they do not want to be in another part of that same financial group and would rather hold the assets externally” says Byrne. But internal segregation is precisely the alternative that well capitalised universal banks such as HSBC, J.P. Morgan and SEB now offer. In fact, in building its prime brokerage business HSBC has chosen to use its creditworthiness and custody capabilities as the twin foundations. Though its ambitions have provoked a sceptical response from market-leading prime brokers, its model is playing well with potential clients. Business is growing and the bank is poised to launch a prime services unit in Asia to complement its existing operation in London. “Yes, all the eggs are in one basket and clients do have counterparty exposure to HSBC Bank PLC” explains Chris Barrow, global head of sales for HSBC’s prime services in London. “First and foremost, investors and hedge funds need to look at the counterparty they are dealing with and be happy with that counterparty from a credit perspective.

Our clients tell us that our model is simple and that they do not have the operational complexities of dealing with more than one party. For example, when we move assets fromthe unencumbered custody account to the charged custody account and back again, this is all controlled by HSBC. There is no need to wait for third party instructions or time delays.” There it is again: the battle against the operational clunkiness of prime custody arrangements [see Sidebar, “Putting the client in control”]. In fact, established prime brokers never tire of predicting that clumsy custodian banks such as HSBC and J.P. Morgan can never match the operational agility and responsiveness of an investment bank. “As soon as you have a bankruptcy remote vehicle or a tri-party custodian, it creates several parties to work with and this can increase the operational burden on the manager” says SEB’s Olesen. He adds that SEB has provided a combined custody and prime brokerage product since long before the crisis. “A lot of our competitors have tried to emulate us post-crisis and we are flattered because it validates what we have been doing all along” he says. “People liked it before the crisis and they like it even more post crisis. It is a custody model so assets are segregated from the bank’s assets. We make things easier for the client.” Chris Barrow argues that he does too. “We have been bridging technology” he says.

“We have built new infrastructure and technology that sits between the global markets business and the custody platform.” At J.P.Morgan, on the other hand, the bank was not content to rely on creating technological links between custody and prime brokerage. In 2009 it set up a whole new prime custody solutions group headed by managing director Devon George- Eghdami, who reported initially to Sandie O’Connor (now head of prime brokerage but then head of financing in the custody arm of the bank) as well as Michael Minikes (the former Bear Stearns prime brokerage chief who was then CEO of J.P. Morgan Clearing Corporation, of which he is now chairman and president). “We were well placed to take advantage of the evolving marketplace” recalls Minikes of the period after J.P. Morgan acquired Bear Stearns. “We had the ability to offer the services of a premier custody bank coupled with a prominent prime broker.” Minikes adds that investors still “want their hedge funds to provide transparency and especially want to know where the assets are held. There is significant demand to have hedge funds hold unencumbered securities in a custody bank.”

Two years on from the appointment of George- Eghdami, the bank has a number of traditional as well as hedge fund managers using its prime custody model. “One of the main benefits of using our product is that clients have a single point of contact and a high level of service” she says. “When a prime brokerage firm is connected to a third party custody bank, there is no control over the level or quality of service to clients. Everything is inhouse here so we control the quality.” If that service quality is judged chiefly by the ability of the bank to deliver consolidated reporting across prime brokerage and custody, it is not the main reason why hedge fund managers are using prime custody services. Nor is it a guarantee that the model will continue to attract balances. As Pierre Emmanuel Crama of Signet Capital Management puts it, “ever since Lehman, the prime brokerage model has evolved and hedge fund managers are constantly evaluating their options.”

What is clear, however, is that prime custody is here to stay. The unanswered question is what the evolution of prime custody will do to the commercial economics of the prime brokerage business. In its heyday, prime brokerage worked like any other banking business. The prime broker took into custody the cash and collateral of its hedge fund clients, and made a spread on re-lending them. Stock lending and financing in exchange for collateral were just the principal tools by which they did this. It follows that, if assets and cash are no longer in custody with prime brokers, or being financed on margin by prime brokers, the revenue and profitability of the business is bound to be seriously affected—and it is. According to the six-monthly survey of the major hedge fund groups in London, published by the Financial Services Authority (FSA), borrowing by hedge funds from prime brokers (as opposed to banks and the repo markets) has shrunk from 24 per cent of the whole when the survey was first conducted in October 2009 to 15 per cent in the latest survey, conducted in March this year. The overall value of short sales tracked by Data Explorers has remained flat throughout that period. In fact, if the revenues of all of the major prime brokers have tracked those of Goldman Sachs, they will currently be running two thirds below their pre-crisis peak.

Five questions to ask yourself about prime custody

1. Prime brokers were like banks. They took your stuff and made a spread on it by re-lending it to other people. If you stop them doing that, what happens?

2. Custodians are still banks. They take your stuff, and charge a fee for moving it between your accounts, unless you agree to let them lend it to someone else. Should you?

3. Moving stuff from a custodian to a prime broker and vice versa means twice the work (two sets of instructions) and half the information (their systems can’t talk to each other). Is it worth it?

4. Your prime broker has put a new label on their trust company and paid a lawyer for an opinion that your stuff is safe inside it. How comfortable are you?

5. You borrow money and you borrow stock from your prime broker. You get clearing, settlement and asset servicing from your prime broker. It might be convenient to buy prime custody too but is it wise?