Segregated accounts

Prime brokers—large financial institutions that provide services to hedge funds—organize fund assets into different types of accounts, each serving a specific purpose. The custody account holds fund assets that remain under the manager's control for the fund's benefit. These assets are kept in a "non-rehypothecated state," which means the prime broker cannot lend them out or use them for its own purposes.

The margin account contains the portion of a fund's assets that serves as collateral. This collateral backs up the fund's obligations to the prime broker or its affiliates, especially when the prime broker helps settle trades on the fund's behalf. Importantly, these securities are kept separate from the prime broker's own holdings and investments.

Under Rule 206(4)-2 SEC Rule 206(4)-2 Rule 206(4)-2 (the Custody Rule) under the Investment Advisers Act imposes requirements on registered investment advisers with custody of client assets, including hedge fund managers, mandating use of qualified custodians, account statements, and surprise examinations. of the Investment Advisers Act Investment Advisers Act of 1940 The Investment Advisers Act of 1940 is the primary U.S. legislation regulating investment advisers, including hedge fund managers, establishing registration requirements, fiduciary duties, disclosure obligations, and compliance standards for advisers meeting certain thresholds. —a federal law that governs investment advisors—registered investment advisers must hire a qualified independent custodianAn independent financial institution hired by investment advisers to safeguard client funds and securities, required by Rule 206(4)-2 to maintain complete separation from the adviser's own assets and operations. to hold client funds and securities. This regulation ensures that hedge fund assets stay properly separated from both the manager's assets and the custodian's own assets. This separation provides crucial protection for investors.

The 2008 failures of Bear Stearns and Lehman Brothers exposed serious weaknesses in how funds protected themselves from counterparty riskThe risk that the other party in a financial transaction will fail to meet their obligations, potentially causing financial loss.. When these major financial firms collapsed, some fund managers who had posted securities and cash as collateral for margin financingCredit extended by prime brokers to allow hedge funds to leverage their investment positions. could not get these assets back. Their counterparties had failed, leaving the funds' collateral tied up in bankruptcy proceedings.

In response to these failures, many managers put new procedures in place. They now require their prime brokers to automatically move all non-collateral assets into dedicated custody accounts at the end of each business day. This practice reduces a fund's exposure if its prime broker becomes insolventA financial state where an entity cannot meet its debt obligations as they come due or has liabilities exceeding assets.. The approach has become a standard risk management tool throughout the industry.

In triparty custody structuresA custody arrangement involving three parties—the fund manager, the prime broker, and an independent custodian—where non-collateral assets are moved to a third-party custodian at the end of each trading day to protect them from prime broker insolvency risk., assets are held by a third-party custodian—an independent institution that is not the prime broker. This custodian is contractually prohibited from lending or reusing these assets for any other purpose. While this arrangement costs additional custodian fees and creates administrative complexity when tracking holdings across multiple institutions, it provides meaningful protection for fully paid assets if the prime broker fails. Cash balances can also be moved into bank accounts that operate separately from the prime broker's own operations.

Managers often choose prime brokers based on the regulatory protections available in the broker's jurisdiction. A U.S. broker-dealerA person or firm engaged in the business of buying and selling securities for the account of others or for its own account. that acts as a prime broker must follow multiple customer protection requirements, including Exchange Act Rule 15c3-3Securities Exchange Act rule requiring broker-dealers to segregate customer assets and maintain reserve accounts to protect client funds, also known as the customer protection rule.. This rule, part of federal securities law, requires broker-dealers holding customer funds to either use those funds in ways that support customer service or keep them in reserve bank accounts that are segregated specifically for customer protection. This prevents the mixing of customer assets with the broker-dealer's operational funds.

Beyond meeting regulatory requirements, segregated accounts provide several operational benefits. They create clear audit trails that make it easier to track assets and transactions. They help ensure accurate performance measurement and proper fee calculations. They also simplify dispute resolution when problems arise.

The segregation protects hedge fund assets from claims by the manager's creditors. If the fund manager faces financial difficulties or bankruptcy, creditors cannot reach the fund's assets because they are held separately. This separation also reduces the risk of asset mixing that could lead to regulatory violations or investor losses.