Hedge funds are reassessing the prime brokerage model in the wake of the financial crisis, creating opportunities for new players to step into the business, writes Kris Devasabai.

The fallout from the failure of Lehman Brothers and the demise of Merrill Lynch and Bear Stearns is redefining the prime brokerage business. Regulatory oversight and counterparty risk are among the issues that must be addressed by the industry in the wake of the investment banking crisis.

The Lehman Brothers bankruptcy has resulted in an estimated $40-70 billion in hedge fund assets held with the bank's European arm being frozen by the administrator, PricewaterhouseCoopers, until the universe of protected creditors can be identified.

The list of hedge funds with assets trapped at Lehman runs into double figures. It includes names like RAB Capital, GLG Partners, Harbinger, Amber Capital and Elliott Associates. These funds could be waiting months, if not years, to reclaim the assets they held with Lehman Brothers in London.

The collapse of Lehman Brothers has underlined the risks inherent in rehypothecating assets. Where assets are rehypothecated into the name of the prime broker, they are at best difficult to identify and extract in the event of bankruptcy. At worst, the assets may never be located, leaving clients to stand in line with other creditors to try and get their assets.

The situation has also highlighted flaws in the comingled account model. Assets held in comingled accounts can be difficult to identify if the prime broker fails, leaving administrators with the task of identifying which assets belong to which clients.

Kate Wormald, founder and managing director of Oesa Limited, says the situation facing Lehman Brothers' clients points to failures in the regulatory regime governing UK prime brokerage accounts.

In the US the re-hypothecation of assets held in margin accounts is subject to regulation by the Securities and Exchange Commission. There are also rules in place to protect cash balances held in prime brokerage accounts. It a similar situation in Canada, the Investment Industry Regulatory Organization of Canada (IIROC) requires that all fully paid client securities be segregated and not used to satisfy the bank's business requirements.

"This segregation process is a daily one with reports being generated and actioned in the securities department. The process is audited by management as well as internal, external and regulatory auditors. In the case of the default of a firm, the segregated assets are pooled, along with other available assets, and client obligations are given first priority," says Adam Jones, director, global equity finance, at Scotia Capital.

The UK has no specific regulations in place to protect assets held in prime brokerage accounts. "In the UK prime brokers have been free to dictate the terms of their agreements with hedge funds. This means they have absolute discretion over the re-hypothecation of client assets and the use of their cash," Wormold says.

"In some cases the prime broker will retain the power to decide whether cash balances are held in a client money account or invested somewhere else like a money market fund even where client money protection has been agreed. Many hedge funds simply end up losing control of their assets," she adds.

Wormald believes the Financial Services Authority (FSA) should step in to ensure prime brokerage agreements in the UK are fair and transparent. "Most hedge funds are not in a position to effectively negotiate their terms and conditions," she says. "The regulator has to step in to ensure that standard provisions are introduced to protect the interests of account holders are included in every prime brokerage agreement and cannot be overridden."

In the absence of regulatory protection hedge funds are voting with their feet. Many have withdrawn their assets from UK prime brokers and the UK branches of overseas prime brokers, sparking concerns about the London's future as a prime brokerage centre.

Counterparty risk

Hedge funds are also looking carefully at counterparty risk. The second half of the year has seen a flurry of new account openings as hedge funds have sought to move away from reliance on a single provider. Other alternatives under consideration include using custody accounts for unencumbered cash and securities and tri-party repo agreements.

"We are going to see a period of reinvention and the hedge fund managers have to stay ahead of the game," advises Wormald.

Bank of New York Mellon (BNY Mellon) managing director David Aldrich says prime brokers can take the initiative by introducing additional controls and risk mitigation processes to strengthen their existing business models. For example, prime brokers can provide additional comfort for clients by using a tri-party collateral management programme to collateralise net exposure. This could help prime brokers to retain hedge business.

"The tri-party collateral management model can help prime brokers to maintain their current business model, while offering additional protection for their clients," Aldrich says.

BNY Mellon can act as a tri-party collateral management agent, sitting between the prime broker and their hedge fund clients. Collateral managed in the programme is held in segregated accounts at BNY Mellon and marked-to-market on a daily basis.

If prime brokers fail to take action to shore up their business model, hedge funds could pre-empt a change in business practices. Aldrich says hedge funds are showing significant interest in services like third party derivatives margin management. "Hedge funds can reduce their counterparty risk in relation to OTC derivative margins by employing a third party agent like BNY Mellon to manage margin calls from their prime broker. If the prime broker files for bankruptcy, margin held with the third party agent will be protected," he explains.

However, Jones says Scotia Capital has not had to change any of its margin methodologies following the collapse of Lehman Brothers. "With regard to re-hypothecation, while Scotia Capital retain the right to re-hypothecate any assets bought on margin, unlike other prime brokers this is not a major revenue generating, and therefore focus, for our business," he adds.

The dominance of the investment banks in the prime brokerage sector has undoubtedly slipped this year, leaving space for others to exploit. Neill Ebers, chief operating officer of Lionhart, a global, multi-strategy arbitrage hedge fund, believes custodian banks are ideally placed to take advantage of this situation and start to make inroads into the prime brokerage business.

"Prime brokers are facing a raft of challenges, unlike those faced before. Hedge funds and their investors have awakened to the dangers of concentrating their business with a single prime broker. It has called into question the logic and moved counterparty credit risk firmly into the sphere of the everyday. The subject and practice of rehypothecation is also being called into question," Ebers says.

Paul Stillabower, global head of business development, fund services, HSBC Securities Services, says hedge funds could turn to custody banks for services traditionally provided by prime brokers. "There are definitely opportunities for custodian banks, specifically those like HSBC Bank that run segregated custody models which are supported by the bank's balance sheet - as opposed to risk management tools and insurance policies - and can offer trading, leverage and administration services," he says.

BNY Mellon's Aldrich also sees opportunities for custodian banks to provide additional services to hedge fund clients. He says funds are already moving their unencumbered cash and securities into custody accounts.

"The existing clearing and settlement capabilities developed by specialist custodian banks to service specifically the broker dealer community could be adapted to meet the needs of hedge funds," Aldrich says.