A recent Financial Times article discussed the ongoing negotiations between prime brokers and hedge funds over financing and trading costs. These negotiations have been brought on by Basel III requirements that mandate banks to report all the leverage on their balance sheets in one or more of several different financial ratios. This in turn makes banks take a hard look at returns for each individual client and financing activity. As leveraged hedge funds take up a good portion of balance sheet at many investment banks, these clients are the most scrutinized for their profitability at current levels of financing charges.

While the FT article pointed out a number of interesting trends, we add that we are seeing a rise of hedge funds using custodians to keep assets worldwide. Whether these services are called Prime Custody or something else, the end result is a transfer of assets away from prime brokers and to custodians. The benefit to hedge funds is that a custodian will charge lower fees and typically a straight fee for assets under custody. For unencumbered long assets (including exchange-traded assets that have leverage baked in), this may be a less expensive solution than keeping all assets at a prime broker. In addition, unencumbered long assets held at a custodian particularly in securities form do not get counted as part of the balance sheet of the custodian itself. On the other hand, both unencumbered long assets and cash are typically counted as commingled assets at a prime broker.

Mutual funds and pension plans using leverage are also looking at custodians for solutions. We like the Enhanced Custody model in particular, so long as clients used to traditional custody can put in an increased amount of due diligence and monitoring compared to a typical custodial relationship. This is by far a less expensive and more efficient way of maintaining leverage than holding assets at a custodian and trading with a prime broker via an ISDA agreement.

Holding assets on the balance sheet and providing access to leverage is getting more expensive: there is no doubt about it. We agree with the FTs synopsis that niche trading markets could get shut down as a result. This is an expected result arising from increased risk management and financing accountability driven by the Basel Committee.

At the same time, increased costs in one area compared to stable costs in another will make hedge funds look for the most cost-efficient business models. Yet again, regulations are proving to create new winners and losers in financial markets. In this case, hedge funds being asked to pay higher fees at their prime brokers will look around for better options. If custodians can offer similar services at a lower price point, hedge funds will gravitate in that direction.

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