London has suffered a setback in the battle with Wall Street for leadership of what remains of the financial world as hedge funds move billions of dollars to New York banks because of worries about the UK bankruptcy regime.

Ironically, assets are being moved because of the failure of Lehman Brothers (NYSE: LEH - News) , a US investment bank. Problems faced by hedge funds and others with money stuck in Lehman's London subsidiary are causing concern.

This week, a group of the biggest US hedge funds warned that London banks would suffer if clients' assets were not returned quickly by administrators as confidence suffered.

"This could be disastrous for UK plc," wrote Richard Baker, chief executive of the Managed Funds Association, in a letter appealing to the Bank of England to intervene.

It is not just US hedge funds that are worried. "It is potentially a problem for London both because of the bankruptcy law and the parallels with the legal structure used by the other US investment banks," said Andrew Baker, deputy chief executive of the Alternative Investment Management Association, the London-based hedge fund trade group. "If you take away the investment banks [London's financial sector] will atrophy. There's no doubt about it."

Prime brokers - arms of banks that service and provide finance to hedge funds - have seen an unprecedented shift away from banks perceived as risky in the wake of the Lehman collapse towards big commercial banks. But, while Morgan Stanley and Goldman Sachs, the market leaders, lost business to JPMorgan, Deutsche Bank, Citigroup, UBS, Credit Suisse and others, hedge funds said they had moved assets from London to New York arms of the same groups.

The loss of prime brokerage assets would have a disproportionate effect on the UK arms of the banks because prime brokers have been the most lucrative divisions. Client assets such as shares, bonds and cash are, in theory, protected if a prime broker fails. As long as they have not been used by the bank for its own financing,they should be segregated and protected if the broker goes bust.

However, none of the estimated $65bn of client assets at Lehman Brothers International Europe, the London arm, have yet been repaid, forcing some hedge funds to tell their clients they cannot have their money back.

Even worse, administrators at PwC who now run the London business say former Lehman clients could wait months or years to get their money back. Last week the administrators won court approval for their planned process to deal with thousands of claims made against the firm.

Steven Pearson, one of the four lead administrators working on the case told the court that administrators had attempted to deal with some cases on an ad hoc basis. But they could not release any assets because of the complexity of Lehman's structure and the need to work out the full extent of each client's relationship with the bank. As a result, funds have looked to the US, where rules are designed to ensure the rapid return of client money. "When the rump of Lehman US went into administration, they had a whole playbook in place designed to unwind and move positions," said one London insolvency lawyer. "We have absolutely no equivalent."

The problem is the duties: administrators have an exclusive duty to creditors, backed up by personal liability, making them put caution and accuracy ahead of speed.

It is not as simple as moving assets from London to New York, however. The prime brokers are set up in different ways, so funds need to check contracts to find out where their assets are actually held.

Many US funds were surprised to find themselves exposed to Lehman in London, even though their relationships were with Lehman in New York.

There are disadvantages to New York, too. The reason banks chose to use London in the first place is that the brokers can offer higher leverage with simpler tax and regulation. Leverage has become much less important as hedge funds cut back borrowing while protection is far more important.

"All of sudden people are seeing that you get what you pay for," said one New York hedge fund manager.