Prime custody seen as growth area for banks

Investor concerns about the safety of assets held in prime brokerage accounts has created a $400 billion opportunity for the provision of custody services to hedge funds under a 'prime custody' model, according to the research and consulting company Finadium.

Finadium expects the total pool of assets eligible for the custodial portion of prime custody services to stabilise at around $400 billion in 2011.

The universe of funds that could use prime custody services might grow as traditional hedge funds reduce their leverage, said Finadium in a paper, "A Primer on Prime Custody".

Finadium identified a number of trends that are driving demand for prime custody services. At present hedge funds are operating with extremely low levels of leverage with fully paid long assets accounting for a significant chunk of their portfolios.

It estimates demand for prime custody will hit a peak in 2010, with up to $700 billion in fund assets potentially becoming eligible for the custodial portion of prime custody accounts.

This market opportunity will shrink as hedge funds increase their use of leverage. According to Finadium, "2009 and 2010 appear to be the peak years for hedge funds and prime custody."

At the same time long/short and market neutral mutual funds are beginning to ramp up their assets under management.

In Europe some hedge funds are launching Ucits funds that typically use less leverage than traditional alternative investments.

These funds rely on a mix of custodian and prime brokerage services and are being offered by hedge funds and traditional asset managers looking to expand their client base.

Prime custody is a hybrid service developed by custodian banks and prime brokers to address concerns around counterparty risk. In a prime custody model, a fund's unencumbered long assets are held in a traditional custodial account, while leveraged positions such as shorts and derivatives are serviced through a prime brokerage account.

Prime custody also incorporates a variety of services beyond the provision of pure custody accounts.

Prime custody services are offered by many of the largest prime brokers, including JP Morgan, Deutsche Bank and Morgan Stanley. These banks have either pulled together existing service lines or have partnered with external custodian banks to create the service.

BNY Mellon and other custodians are also offering their own versions of prime custody.