Prime Custody: One way for hedge funds to protect against “being Lehmaned”
| Jul 12th, 2010 | Filed under: Hedge Fund Operations and Risk Management, Today's Post | By: Guest |
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Special to AllAboutAlpha.com by: James Burron, CAIA
You’d be excused if you felt confused about recent changes to the prime brokerage, custody and fund administration business. Goldman Sachs is working with BNY Mellon; Deutsche Bank has a new platform; Merrill Lynch heralds changes to collateral management at industry conferences etc. In the post-Lehman world, has “boring” simply become hip, or is there really change afoot? To understand these changes, you have to go back in time, way back.
Our story starts with the birth of hedge funds themselves. Alfred W. Jones had the groundbreaking idea to start a fund that was long and short securities (and charging a performance fee) such that returns and risk might be optimized. However, short-selling was easier said than done. When I was a boy, I thought brokers had securities in their desk drawer to produce to investors when they wanted to buy them – just like trading cards. [Ed: when I was a boy, I didn't know what a broker was...].
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From an operational due diligence perspective, attention should be directed to the remainder of the assets that are not being held as collateral for the loan. To further mitigate counterparty risk, one should ensure that the unencumbered assets are not contingent to re-hypothecation at the PB/Agent entity and a detailed review of the loan agreement and asset return/replacement should take place to ensure full ownership of fund assets.
At a high level, securities loan and cash financing provided directly from the custodian entity and not a traditional PB, should be subject to the following review to reduce operational risks :
What is the scalability and robustness of the custodian securities financing technology?
Does this technology have real-time reporting and web-access to review positions and margin?
Is there seamless connectivity with fund accounting and other internal platforms?
Is there any pooling of client cash and un/encumbered assets within custodial and securities lending platforms?
What is the skill-set and understanding of alternative investments within the custody team?
What is the pricing methodology and is it transparent?