The very real effect of losing faith with the banking industry can be seen amongst buy side firms. The fund management business is based on trust - well, money and trust - and realising that faith in a top five broker was misplaced required quite a rethink of the business model.

"What drove hedge funds towards segregated custody - which is what we're seeing a demand for - is basically safety and soundness," says Devon George-Eghdami, head of prime custody at JP Morgan. "The events of 2008/2009 brought to the forefront the inherent operating risks of running a hedge fund"

All through the financial chain, from the retail investor to the pension fund to the hedge fund to the service provider, fear is slowing investment says Chris Cattermole, head of Geneva sales EMEA at Advent Software. "Investors are more institutional, often pension funds, and they are carrying out more rigourous due diligence on where they put their money. From a technology standpoint that makes it important for the fund to show they aren't operating on an Excel spreadsheet but on a true multi-prime platform, to get their true exposure, their true counterparty exposure and understanding of where the cash resides."

Lifting the hood

As the focus moved from investment strategy and alpha to client retention and trust creation, the business needed to change, both for funds and their supporting banks. Activities that had previously been a normal - some would say low risk - part of doing business, have such as securities lending, fell under scrutiny. "All sorts of areas have been re-examined because people got burned in ways they never thought could happen," says Tony Freeman, head of industry relations at Omgeo. "It affected sub custodian arrangements such as whether a prime broker could relend or rehypothecate assets."

Where before there was an expectation to see boxes checked, now investors and funds wanted to check the working behind the tick, and understand how it worked. "The overall effect, and it has taken a while, is that there is an awful lot more rigour around the operational management process in the post trade area," adds Freeman. Moving from a ‘booming' market, means that the spend which was previously directed at front office technology - trading, research, performance measurement - is moving. "Previously the back office could be casually outsourced to prime brokers and you could just expect things to happen. Now they want to know how things are happening and often prime brokers aren't equipped to provide that level of insight and so the funds are turning to custodian banks instead."

George-Eghdami says that this drove JP Morgan to address its own separate business models for prime brokerage and custody, "After the bankruptcy of Lehman Brothers, many hedge funds became concerned about where their securities were held and whether they were being rehypothecated. This gave rise to a desire to segregate their long positions from the assets they held in their margin accounts at a prime broker."

New model custody

As a result, JP Morgan created its ‘prime custody' function to offer all of the services that both traditional fund and hedge fund clients required. A single point of contact was able to offer custody, fund administration and fund accounting integrated together for hedge funds, while for traditional fund managers it offered market neutral or long / short strategies rather than long only, as they strived to retain the investors they had and raise new money.

The bank took the securities services and prime brokerage businesses that had been separate and joined up the technology platforms that they were running on, giving a single view of the custody and prime brokerage accounts for a client. It also assists with more complex issues, assisting a client to relocate an offshore fund to a new location such as Ireland or Luxembourg that will provide some regulatory supervision.

"Aside from hedge funds seeking to protect their unencumbered assets, you're also seeing the hedge fund managers launch ‘40 Act funds, to get access to a broader range of investors" says George-Eghdami. These fund structures, by regulation, are required to use a segregated custodian. "We have seen increased interest from the large traditional fund managers in the US who are moving to a blended strategy of long and short. This increased interest is driven by changing investor demand as a result of market performance over the last two years. In order to continue to raise assets they are trying to offer a greater range of products to their existing client base."

There is understandable concern amongst buy side firms that all of their eggs may be in one basket/broker, and this has led to a growth in multiple broker relationships, by which the funds  limit the risk of a counterparty defaulting in the manner of Lehman brothers.

That in itself can add to risk says Neil Puri, chief executive of Statistical Research Laboratories, an investment systems specialist. "In the post Lehman world counterparty exposure is clearly the key concern for both investors and managers. With diversification, however, a number of issues beyond the reporting complexities of having multiple counterparties are apparent. There is no longer a holistic view of the underlying inventory. Banks themselves require transparency to truly assess the money manager's risk. Consider the extreme example of a manager with two prime broking relationships - the account at one going short and at the other going long, with each prime broker seeing incomplete information". As he notes, "Risk isn't additive. If manager A is long on Vodafone and has a risk of x and manager B is short on Vodafone and has a risk of y, then net net you're flat on Vodafone, but your risk position is not  simply the risk of manager A plus the risk of manager B, you need to know the underlying portfolio positions."

Other prime brokers are targeting funds that do not have the capacity to provide their own operational infrastructure, needed to support the increased amount of information requested by both funds and investors. This is in turn leading to further innovations in business models, such as mini-primes. "Mini-primes are an ‘introducing prime' backed by some of the large names in the industry," explains Cattermole. "They don't provide clearing and financing for the funds, they are doing things like capital introduction and consolidated reporting for the hedge funds. So they act as a conduit between the funds and the multi-prime environment." This servicing involves getting a tighter grip on data and information on a more timely basis he explains "Things happening intraday, corporate actions, expiry of futures, accruals, certain things that traders need to be notified about, so monitoring trading activity and operational activity starts to become more of a daily process. The requirement of speaking to the fund administrators once a week or once a month becomes daily, the requirement to speak with the prime broker becomes more frequent, and it's more of a hands on approach."

Initially a US development, mini-primes are seeing increased interest in EMEA and are likely to be popular among smaller funds that wish to outsource technology and operational functions but do not have the investment levels to make them financially viable customers for bigger brokers Cattermole says, "As a business they might be able to tap into the lower threshold of hedge funds that don't have a huge amount of investment. Rather than the fund going to many prime brokers, the mini prime takes ownership of the servicing side of things. They target the smaller funds in the £20-30 million range that larger primes don't have the appetite for. Some of them even outsource the trading. The trader just plugs in the trades that the portfolio manager has chosen."

The trend is towards more cross-over between the funds says George-Eghdami. "We are seeing the start of a recovery and so asset managers are now raising new money. Six months ago we were educating people but now we're executing deals. Asset managers have gained experience from the tough market and they now know what they need to do on an operational basis to address investor concerns."

Two years from now, she says, it will be commonplace for a hedge fund to have a custody bank. It will also be more common - although not as commonplace - for traditional asset managers to have people to talk to about getting short.

Puri says that regardless of strategy or structure, "The big question, if you're a service provider - a custodian, an administrator or prime broker, is who owns the assets - with a managed account the investment manager is now a trading advisor and the sponsor of the fund, i.e. the owner of the assets is now the client. In the new world, the lines are blurred, with the investor now more than ever needing to see what's what."

Now pension funds are seeing the potential that hedge funds offer, albeit in more complex products, but there is a still a question to answer - who is the end investor? Should the true end investor be told about their exposure to hedge funds? Because that would be true transparency for the man on the street.

Puri believes that there will need to be an investment in technology or the problem outsourced. "This extra reporting poses an additional burden on the money managers and their prime brokers in turn. However, the banks don't want to be technology houses anymore. That's one big change. For a money manager you eat what you kill and there are no free lunches - or not for much longer. So you have to focus on your core business and outsource the rest."

Further technology investment, in the algorithmic space, should facilitate access to managed accounts by driving down the costs of the management through automation. With access to managed accounts investors will in turn have a higher touch relationship with their investments. This will perhaps lead to a greater move towards transaction based investment, rather than the previous reliance upon market growth. 

If this were the case - and regulatory measures like MiFID have driven down costs, making transaction based business models more appealing - then the long-only fund could see a further retreat in its battle against high frequency trading. Regardless of the effect that such a change would have on long term investments, the transparency of the businesses would be much improved.  With regulators in the US now asking to examine the trading activity of ‘large traders' - defined as a person whose transactions in equal or exceed two million shares or $20 million during any calendar day, or 20 million shares or $200 million during any calendar month - the market as a whole should find itself clearer.