Investment banks and prime brokers offering prime custody have seen an increase in demand for the service following the fall out from Lehman and market turmoil in the eurozone. SEBs prime custody business has seen a notable uptick in demand in the last few years as an increasing number of hedge funds look to move away from the previously dominant prime brokerage model, which was based on a rehypothecation of assets, in the pre-Lehman era.
While SEB does not publicly provide the prime custody division revenue numbers, the company says its numbers were up significantly on last year. The UK especially saw strong revenue growth year on year in 2011, double the growth seen for Nordic clients.
Sharing his thoughts on reasons for the growth, Atilla Olesen, head of SEBs prime brokerage and securities finance operation in the UK and co-head of SEB Enskilda Equities UK, Olesen says: The last 10 years can be split into three historical periods: pre-Lehman, just after Lehman and what has happened up to now. Pre-Lehman the dominant prime brokerage model with full rehypothecation of assets used by US investment banks showed them to be extremely vulnerable during the crisis because all they were left with was clients assets when the interbank market collapsed. Rumors then led clients to start pulling out their assets as they were not segregated from the prime brokers if they went down. This is what killed Lehman.
After Lehman, says Olesen, the next historical period focused on counterparty risk, when new initiatives such as bankruptcy remote vehicles, comprising a separate legal entity that clients could contract with for prime brokerage, came to the fore. This safeguarded the assets in the event of a broker dealer bankruptcy. The problem with that is in the event of a bankruptcy is the infrastructure there to deal with the assets? If you look at the case of Lehman people were locked out of the building.
Tri-party finance agreements between custodian, hedge fund and prime broker were the second model to emerge post-Lehman, observes Olesen. However, assets can be lost here too when they are transferred between the three parties, he says. It is a reasonably safe model, but it is also operationally heavy. It is not just bilateral, it involves three models and the day to day becomes slow.
The last model, says Olesen, is the custody-based prime brokerage model or prime custody model, involving a full segregation of assets before and after the trade. While SEB has been offering this model for many years, Olesen says clients are now more interested and more aware of it. Here the prime broker provides the hedge fund relationship while utilizing the custodians operational expertise. This is operationally efficient and cost effective.
Olesen says pre-Lehman there was limited awareness of the prime custody model. Then markets stabilized post-Lehman, concerns disappeared and raising capital came back onto peoples agenda. Then the whole discussion around counterparty risk intensified. Indeed counterparty risk has been given considerable attention since the collapse of MF Global in October.
The prime custody model has been rolled out by a handful of other investment banks in recent years, including J.P. Morgan this year and HSBC in 2009.
(JDC)