Custodians that offer agency securities lending are increasingly lending directly to hedge funds, reducing managers' reliance on prime brokers that have traditionally borrowed securities on their behalf. But some industry players say this model has its limitations.

The trend is largely driven by institutional investors' requests that hedge funds deliver better cash and liability management and reduced cost, says Paul York, Asia head of securities finance trading at State Street Bank and Trust. He was speaking at an industry conference organised by the Pan Asia Securities Lending Association (Pasla) in Hong Kong earlier this month.

Custodians call such service “prime custody” or “enhanced custody”, and it involves effectively managing all the additional client and regulatory reporting functions on behalf of fund managers, as well as acting as agent lenders in some cases.

This reflects a structural shift in the sec-lending industry, whereby custodians are starting to compete directly with prime brokers.

“Some agent lenders are lending directly to hedge funds, and [at the same time] borrowing from other agent lenders, prime brokers and hedge funds themselves," says York. "The days of traditional agent lenders being just lenders is over."

The traditional role of an agent lender is to represent beneficial owners of securities – typically pension funds or insurance companies – to lend out stocks for a fee. They would usually use intermediaries such as prime brokers or securities firms. 

But increasingly rigorous demands from institutional investors, which in many cases have replaced high-net-worth individuals as typical investors in hedge funds, means managers are more willing to outsource time-consuming regulatory reporting and cash management functions – including stock lending – directly to their custodians, York argues.

Another reason that agent lenders are increasingly providing sec-lending services directly to hedge funds is that some institutional investors already being serviced by these custodians are branching out into hedge-fund strategies, say industry players.

Hence, rather than introducing these clients to prime brokers for securities financing and potentially losing assets to them, the agent lenders would rather provide sec-lending services on top of custody and fund accounting.

However, some industry players who attended the various panel discussions at the Pasla conference indicated that not all custodians are willing to take on hedge fund clients. Ultimately, they say, there is still a fundamental difference between prime brokers and agents.

Prime brokers usually rely on rehypothecation – relending the collateral pledged by hedge fund managers/borrowers for securing their stock loan as collateral for banks’ financing needs. Broker-dealers say their ability to rehypothecate chiefly explains the lower funding costs they can offer hedge fund clients. Agent lenders do not finance clients' short positions.

Moreover, executives at prime brokerages and agent banks argue that the custodian-backed lending business model only works up to a point.

“It depends on the type of hedge fund,” says one executive at an agent bank. "If a hedge fund needs leverage from agent lenders, [sec-lending by custodians] won’t work, as custodians won’t provide leverage on the underlying assets of the hedge fund in addition to sec-lending and custody."