Could you explain State Street’s enhanced custody and how it differs from traditional prime brokerage?
Much like conventional prime brokerage, we provide financing and securities lending direct to the end users. This is different from our agency securities lending programme, in which we lend through the intermediaries or the other prime brokers to, and ultimately onto, the end users.
We have a direct financing and securities lending relationship with our customers, who are—in many cases—similar to the customers of all the other major prime brokers.
In many ways the product is similar, in the sense that what we are able to offer the customers a financing product that is similar to what they will get from one of the investment banks.
However, we do the financing and securities lending within the enhanced custody business, within the context of a custodial account. So the fund deals with the bank directly and they finance their portfolio out of their custodial account.
We lend securities into their custodial account, which is a little bit different from dealing with a broker-dealer and utilising a margin account. The assets are ring-fenced and the customer has full transparency into the account at all time because it is, in fact, a custodial account.
How does rehypothecation play into this difference?
The way in which we use rehypothecation is different to the traditional model. We have to finance the customer’s assets and there are a couple of ways we can do that.
Firstly, the customer can participate in our agency securities lending programme. That is a programme we refer to as self-financing; they can finance their borrows by lending in our agency programme. Rather than invest the cash proceeds in a collateral vehicle, they can use those cash proceeds to borrow securities from us.
They can also pledge their assets in a custodial account and we can use the liquidity on our balance sheet to support the transaction. Our customers value the liquidity on our balance sheet, particularly in times of market stress.
Our options differ from what I think of as a conventional margin account at a broker-dealer: where a customer puts their assets in the broker-dealer’s name and the broker-dealer, in turn, rehypothecates those assets. The customer can use their assets to finance their borrows with us, but it’s all done in and out of their custodial account.
How does the enhanced custody lending business compare to the agency lending business at State Street?
Ultimately it rolls up into common management here at the bank, but it is a totally separate business. We are a top ten borrower from our agency’s securities lending programme but it is a different business.
Our customers view this product as a complement to prime brokerage. There are many things that the investment banks offer that we don’t and we offer a unique financing value proposition that is unrivaled.
Most funds today multi-primes and there are a lot of good reasons why they decided to use some of the different investment banks for prime brokerage services.
We are trying to be the fund’s custodian, administrator, and alternative financing provider. We try to keep it simple and leverage what is good about State Street, and offer that to the alternatives community. We interact with the agency lending programme just like any other counterparty would.
How have you seen the dynamic change between fund managers?
My perception is that investors are asking for a lot more transparency. Reporting requirements continue to get more complex over time, and there are more boxes to check. Clearly around the world we have a more active regulatory community, so all of this is making life more complicated for managers and driving up administrative costs. As a custodian and an administrator dealing with these issues is our bread and butter. To me, the problems are making the fit— particularly between those in the hedge fund space and the services we can provide as State Street—make more and more sense.
A State Street report describes enhanced custody as providing solutions for hedged mutual funds. Is this a typical client for you?
Today our customers break down as 60 percent hedge, and the remaining 40 pretty evenly split between institutions—public funds here in the US, endowments, etc—and mutual funds.
Mutual funds—institutional investors who act under a ’40 Act structure—are, from what I see, beginning to have more traction in the alternatives space. Because of our market share in the servicing business with mutual funds in particular, the relationships we have, and some of the operational efficiencies we can provide by allowing a mutual fund to do its financing and securities borrowing here within our custodial account, we are excited about the growth opportunities in that space.
We have seen a handful of launches over the last couple of years and some traction, like I said, with some of the customers, and that is a fast growing customer sub-segment in the mutual fund space.
How has the US Dodd-Frank Act/Basel III affected the business?
Some of the issues relating to Basel III such as the leverage ratio are going to be a top consideration for us as well as everyone else. If anything, in regards to Dodd-Frank I think the principal lending business here will provide some counterparty diversification and help mitigate some of the counterparty concentration issues that our agency programme faces under Dodd-Frank Rule 165 in particular.
The good news here is that we can diversify our exposure away from the 10 largest investment banks and spread some of that across many funds in the alternative manager customer segment.
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