Convergence between hedge fund and traditional long-only investment strategies is re-shaping the business of prime brokers and global custodians, according to new research by the Vodia Group.

Prime brokerage continues to grow by impressive bounds despite the credit crisis and collapse of Bear Stearns, Vodia said, driven principally by the rapid expansion of traditional asset managers into hedge funds, 130/30s and other leveraged trading vehicles.

According to a recent Vodia Group survey traditional asset managers have 3 per cent of their asset base - equivalent to $1.95trn - in leveraged investments, with 86 per cent of major asset managers expecting to run 130/30s by mid-2009. The firm predicts that leveraged assets will increase from $2.65trn today to $4.48trn in 2012, driving greater demand for prime brokerage services.

But traditional asset management clients are forcing prime brokers to adapt their business model, placing greater emphasis on custody, reporting and risk management and de-emphasising capital introductions and leverage. These factors will push margins lower and increase operational requirements in the prime brokerage business, Vodia said.

Josh Galper, managing principal at Vodia group, told ICFA: "Although custody balances are rising sharply, this does not mean that profits will rise in lock-step. Much of these new assets use less leverage than typical independent hedge funds, meaning that margins at prime brokers will fall."

In the wake of the Bear Stearns failure, the firm also expects to see prime brokers enter a new age of transparency and disclosure around net capital and liquidity requirements, with the Federal Reserve seeking to enforce a new layer of regulation for major brokers.

Galper said: "Bear Stearns collapsed because of a lack of transparency on their credit and liquidity balances. SEC data after the fact show that Bear's net capital and liquidity were quite strong until the last days. In effect, the fears of Bear's collapse were vastly overstated relative to the reality."

In order to allay rumors, brokers may in future take action first to disclose their capital and liquidity, driven by the needs of their clients or shareholders.

In its research report Vodia presented a methodology for evaluating broker-dealer margin balances and liquidity risk, and unveiled a model for calculating a ratio that assesses credit exposure versus readily available capital to give a ranking of the liquidity of prime brokers.

The Vodia report - entitled "Traditional asset managers, credit and transparency in prime brokerage" - also provided an insight into the battle for hearts and minds being waged between custodians and prime brokers.

A Vodia survey of a sample of firms listed on the P&I/Watson Wyatt top 300 global asset managers list found that 78 per cent of traditional asset managers were more comfortable using a traditional custodian to service their long/short assets, while 67 per cent preferred to receive securities financing from a traditional prime broker.

Almost half the firms surveyed (43 per cent) believe the prime brokerage and custody businesses are converging, while 38 per cent of asset managers who custody their long/short assets at a prime broker have that relationship set up as a sub-custodial arrangement to their traditional custodian, with the prime broker reporting positions and accounts to the custodian. The general feeling was that prime brokers are heading towards the traditional custody world as opposed to vice-versa.

Vodia expects to see a great deal of systems development and variation in reporting arrangements in the years to come as the prime brokers adjust to the needs of large asset managers.