In preparing an August research report on liquid alternatives and leverage patterns, we started to think about who gets the business when prime custody or enhanced custody maxes out? We expect that there are limits to how far prime custodians can go in a liquid alternatives market that could reach US$2 trillion AUM. What happens then?
The idea of prime custody is to offer a long/short manager the opportunity for all the traditional services of a custodian, plus the ability to lend out securities and generate cash for margin, and borrow securities from the custodian’s securities lending program. The program “makes a lot of sense” according to the asset managers that participated in our 2015 survey in securities finance. The best clients for prime custody are hedge funds that have specific leverage needs (and that either don’t need or have been evicted from prime brokers); regulated mutual and UCITS funds; and single account holders like pension plans that have long-only assets at a custodian as well as an internally or externally managed long/short fund under the same tax ID. Prime custody is not prime brokerage and its not supposed to be. It is low balance sheet utilization and a mix between custodian and prime brokerage service levels. Top 100 hedge funds expecting a 10 minute turnaround to complex trading questions need not apply. For its audience though the model does make a lot of sense.
Prime custody does not have infinite resources however. One limit is how much borrowing can a custodian do from its securities lending division. According to State Street’s 2014 annual report, “As principal, our enhanced custody business borrows securities from the lending client and then lends such securities to the subsequent borrower, either a State Street client or a broker/dealer.” The demand for this service is growing quickly. Again from State Street’s 2014 annual report: “Securities finance revenue increased 22% in 2014 compared to 2013. The increase was mainly the result of growth in our enhanced custody business and the impact of higher lending volumes associated with our agency lending program. Revenues from our enhanced custody business totaled approximately $121 million and $61 million, respectively, in 2014 and 2013.”
There are limits on both the balance sheet capabilities of custodians as well as the maximum counterparty exposures that clients may allow. These numbers vary but are finite; increasing success will ultimately hit a wall.
Externally there are limits in how much the market will bear. For example, when clients want to finance GC securities to generate cash, how much of a market will there be? What will borrowers pay for GC and give back cash? Could those fees just go negative and look like equity repo, and even then, what kind of demand would the market hold? Would internal cash investment pools be able to or want to hold that equity repo? These are tricky questions, but the answers are increasingly looking like there will be limits to market demand for GC. This in turn will take away the ability of prime custody clients to self-finance, will increase costs, or both. The prime custody model is built on market liquidity – many other businesses are too so prime custody is certainly not alone – but prime custody clients will again hit a wall if borrowing demand for GC dries up.
How about on the borrowing side? We don’t see much limit there. If a prime custodian can still borrow securities from its internal clients and lend them to a prime custody client, then all is well. We’ll give this issue a pass for now.
What happens after prime custody for investment managers? One answer is moving still further downstream in the size of securities firm that managers deal with. This requires market liquidity though otherwise the smaller firms also have nowhere to turn. A second answer is a rethink of the portfolio strategy to move away from physical financing. That could be complicated and painful. A third answer will be detailed in our August report. But as an asset manager in our survey said, will moving away from prime custody “be a good credit call and what happens to client perception?” Prime custody is worth the while, but investors would be wise to ensure that firm and market capacity constraints don’t get in the way of a good thing.