Investment management is as much a part of Boston as tea parties and Red Sox. In 1893, the launch of the Boston Personal Property Trust introduced the closed-end to the United States, while the creation of the Massachusetts Investors’ Trust, in Boston, marked the arrival of the modern mutual fund in 1924. Today, many Boston-based investment managers are global, and many global investment managers have a presence in ‘Beantown’.</p> All of them have been facing up to a massive change in derivatives market structure in recent years. Ever since the G-20 leaders identified the opacity of the OTC derivatives markets as one of the biggest sources of systemic risk to the global financial system, all market participants have been preparing themselves for a raft of substantial changes. For investment managers, it has meant taking responsibility for processes and procedures that previously they left to their banks and brokers.</p> In short, the G-20 leaders decided, at a summit in Pittsburgh in 2009, that as many OTC derivatives transactions as possible should be centrally reported to trade repositories, cleared by central counterparties and traded on exchange-like electronic platforms. In parallel, regulators in Basel decided that banks had to set aside more capital against high-risk activities, including the trading of OTC derivatives. So for the many investment managers that traditionally picked up the phone to their broker to arrange an interest rate swap as part of the everyday management of a client’s bond portfolio, a whole slew of changes loomed into view.</p> Most importantly, the investment manager would no longer face off against a broker from a credit and counterparty risk perspective. The clearing broker would still play a role in establishing the investment manager’s creditworthiness, but the counterparty risk for each transaction would now be assumed by a clearing house in return for the posting of collateral by the investment manager. On the trading front, investment managers would need to execute OTC derivatives transactions via trading protocols that showed a clear audit trail, seeking best execution while brokers attempt to protect their margins, prompting concerns over potential liquidity shortages.</p> As the largest OTC derivatives market in the world, the US is further down the path in implementing the G-20 recommendations than any other jurisdiction. Under the auspices of the Dodd Frank Act, 2013 saw the introduction of reporting requirements, central clearing (in three tranches) and the launch of new trading platforms – swap execution facilities (SEFs) – use of which for certain highly liquid swaps became mandatory in Q1 2014. Europe is slightly more than a year behind. In February, reporting requirements came into force for virtually all market participants (in the US, only brokers have reporting obligations) while clearing is expected to start by the end of this year or early next. The requirement to trade on new platforms – organised trading facilities (OTFs) – is scheduled to kick in by 2016.</p> Fundamental change</h3> BlackRock, the US-headquartered multinational investment management firm, has taken a very proactive approach to the changes to use of OTC derivatives. Supurna VedBrat, the firm’s co-head of electronic trading and market structure, says the Dodd Frank Act has “fundamentally changed” the firm’s OTC derivatives trading and investment strategy by limiting bilateral trading and designating clearing houses as intermediaries of counterparty risk. For VedBrat, there have been positives and negatives so far. The decoupling of execution risk and counterparty risks, for example, means asset managers like BlackRock can trade with a greater number of executing dealers, which is advantageous as the number of dealers has fallen since 2008.</p> Centrally clearing swaps reduces counterparty risk and is a step towards the development of standardised swaps contracts, but the migration to the new environment, and especially the different pace of reform across jurisdictions, can have negative implications for liquidity. “There has been some regional liquidity fragmentation due to a bifurcation of cleared and bilateral swaps and a grouping of participants as US person and non-US person, as region-based rules are applied to the global OTC derivatives market. SEF trading will further fragment liquidity by distributing it across multiple platforms. We have prepared for this and will continue to enhance our ability to aggregate this fragmented liquidity,” explains VedBrat. One of the challenges that US investment managers are facing up to is whether to connect directly to all the new SEFs – there are almost 20 at present – or use some kind of liquidity aggregation capability, either from a broker or a third party. Even if aggregation tools are used, the changes required to investment managers’ processes and technology should not be under-estimated.</p> “Ensuring our trading strategies and systems can properly adapt to these changes while meeting the regulatory requirements for straight-through processing has underpinned our overall approach to the SEF trading,” says VedBrat. “The client documentation required to support this new trading flow had to be negotiated, which added complexity to this shift as the successful execution of a single swap requires at least six external parties, including the SEF, futures commission merchant and clearing house.”</p> Overall, US investment managers have taken a cautious approach to trading on SEFs so far, with very few trading actively ahead of ‘mandated to trade’ applications by SEF operators, which became effective in February and March. Most of their attention, in the US, Europe and beyond, has been focused on clearing OTC derivatives, and understanding the collateral requirements of clearing houses. “We have dedicated significant resources to meet central clearing requirements,” says BlackRock’s VedBrat. “Given the exposure to central counterparties (CCPs) and the amount of collateral clients must post, we have a robust process of evaluating our counterparty risk to CCPs and their clearing members and an analysis of the types of risk we are willing to take in the OTC derivatives market.”</p> Turning off the tap</h3> Concerns over a possible collateral shortage have been rising across the financial markets for most of the last five years. Over the past 18 months or so these concerns have been kicked down the road by the combined actions of the European Central Bank, the Bank of England and the Federal Reserve. Ongoing injections of cash into the financial markets in support of macro-economic objectives have meant market participants have not yet faced the expected squeeze from post-crash regulation, specifically Basel III and OTC derivatives reform.</p> But sooner or later the tap will be turned off by the central bankers and the increased cost and lower availability of funding will raise familiar questions. Basel III hikes demand for high-quality, liquid securities via the introduction of the liquidity coverage ratio and the net stable funding ratio as well as the levying of new credit valuation adjustment risk capital charge against counterparty credit risks. This charge is widely considered to be so onerous as to drive market participants to centrally clear OTC derivatives rather than trade them bilaterally, thereby contributing to the increasing demand for collateral considered eligible for margin payments by central counterparties.</p> All this coincides with the migration of OTC derivatives to central clearing in both US and Europe, making calls on collateral to support margin payments by investment managers and other derivatives users to clearing houses that much more urgent.</p> A whole range of different arrangements exist at present, from the investment managers that handle credit support annex agreements with a handful of brokers via a spreadsheet to those that have outsourced collateral management to a custodian or asset servicing provider to the larger firms that may have their own repo desks.</p> But all users of OTC derivatives are being made to think again. Differences in their risk management models notwithstanding, most CCPs currently demand initial margin be paid in cash or high quality collateral, typically AAA-rated government bonds, while variation margin is payable in local currency cash. For performance reasons, investment managers don’t tend to keep piles of cash on permanent standby, so those that use liquid credit and interest rate swaps are likely to need to upgrade their current levels of collateral management, perhaps to an intraday basis, to meet variation margin needs.</p> In Europe, the picture is more complex than in the US. The wider range of segregation models required under the European market infrastructure regulation is increasing the number of accounts that will need to be held at CCPs by investment managers for their multiple funds and clients. Segregating individual funds makes them safer, but entails much more administration and oversight to ensure they are fully collateralised at all times. As such, the task of meeting collateral requirements across multiple accounts and multiple CCPs in a period of unexpected market volatility may quickly become unmanageable.</p> Large investment managers and other buy-side firms already use available market mechanisms such as repos and securities lending to obtain collateral as part of their trading and investment operations. But with more types of trading activity being collateralised and the rules around supplying collateral being tightened, collateral will be in greater demand. How much more? We just don’t know because the regulatory environment is only gradually being rolled out. But evidence suggests asset managers will need to take a much more proactive approach to collateral management if they are to continue to access the markets they need cost-effectively.</p> The global firms might have the deepest resources but they also may have the most complex challenge as pockets of eligible collateral are likely to be spread across geographies and legal entities. And while some firms may have previously outsourced collateral management responsibilities to sell-side counterparts, the regulatory-driven shift to intra-day if not real-time oversight of collateral is leading both asset managers and their brokers to conclude that this is a process that should be taken in-house.</p> Optimise your assets</h3> Godfried de Vidts, chairman of the International Capital Markets Association’s European Repo Council, sees the growing need to manage collateral proactively as a conceptual and operational change for asset managers. “It’s no longer a matter of buying a bond and sitting on it; you have to make it work for you. At the same time, you don’t want to over-collateralise. You need to be pretty sophisticated to make optimal use of your assets,” he says.</p> If you give a bond as collateral in a repo transaction for one-month cash, for example, you need to have the flexibility to provide more cash the next day in the event of a margin call, but you will also need to be able to replace the bond if you need to sell it the following week. These in and out flows and the daily margining that accompanies them can be difficult to master operationally.</p> As well as choosing the right segregation models, reconfiguring and very likely centralising internal workflows and using technology to optimise management of collateral, a further key consideration for investment managers is their approach to the securities lending and repo markets. In their different ways, these provide asset managers with the opportunity to actively manage their available assets in accordance with their collateral requirements.</p> While the securities lending and repo markets can assist the flow of high-grade assets to provide institutional investors with sufficient collateral to pay margin to central counterparts, existing documentation, market practice and regulation are not necessarily geared to this end.</p> For global asset managers, the cost of posting collateral at clearing houses needs to be assessed against their responsibilities to clients’ assets. Eric Böss, head of derivatives at Allianz Global Investors, reflects the priorities of most investment managers on the level of asset segregation and protection required from clearing houses.</p> “I would consider it our fiduciary duty to have the highest level of segregation for our clients, but we have to be aware that it comes at a cost, because it will reduce the netting effects at several levels of the financial value chain,” he says. “But other market participants are driven by different requirements, such as deploying capital efficiently, so the market should be able to offer a range of levels of segregation, for example to banks that might want more netting and lower cost.”</p> Cost considerations</h3> Uncertainty over their ability to secure the required collateral is causing many investment managers to consider moving to exchange-listed futures instead of swaps. There is increasing competition and innovation among derivatives exchanges, all spurred on by the fact that futures margin payments are calculated on a two-day value-at-risk basis rather than five for swaps. Much depends on who and how you use derivatives in the first place.</p> For many investment managers, use of both interest rate and credit derivatives stem largely from their management of bond portfolios. While the former typically offer protection against default, interest rate swaps are mainly used to manage duration within a portfolio, adjust interest rate exposure across the yield curve or take a view on credit spreads. Because a bond portfolio is made up of hand-picked issues, adjustments to take account of interest rate expectations are achieved by buying or selling futures, rather than making a fundamental change to the constituents of the portfolio. They are also used for liquidity management purposes. “If there is a large inflow into a fund you might buy futures as a proxy for some of the less liquid bonds in your portfolio,” says Böss at Allianz Global Investors.</p> Over the years, OTC credit and rate derivatives have become more standardised in structure, and more like exchange-listed futures in economic exposure provided, but the replacement of OTC swaps with listed futures has been very slow. For example, an iTraxx credit future launched by Eurex in 2007 failed to secure market share. The German derivatives exchange has consulted the market on the planned Q3 2014 launch of euro-denominated interest rate swap future. Although OTC interest rate swap instruments aren’t quite as standardised as credit default swaps, there is good reason to believe next time will be different, at least for some buy-side firms.</p> “It is perfectly possible to reduce duration with futures, especially for large firms with a scalable, well-established STP infrastructure for trading on derivatives exchanges. Moreover, the futures clearing environment showed it was able to handle the default of MF Global, whereas the new swap clearing environment has not yet had a chance to prove itself. When selecting duration management tools, the buy-side’s considerations will change, but they will not be one dimensional. There are no signs yet that listed futures will close down the swaps market.”</p>