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 of the —a federal law that governs investment advisors—registered investment advisers must hire a 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 . When these major financial firms collapsed, some fund managers who had posted securities and cash as collateral for 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 . The approach has become a standard risk management tool throughout the industry.

In , 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. that acts as a prime broker must follow multiple customer protection requirements, including Exchange Act . 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.