Buy-side firms are reshaping their operations to cope with the effects of OTC derivatives regulation, finds Dan Barnes.
As regulators transpose G20 policies into legislation, strengthening the global over-the-counter derivatives market, fund managers are being asked to do more work per trade, forcing them to make either big internal investments or to use third-party providers for support.
“There's always a cost burden to regulatory compliance and it is one of the more challenging factors of doing business,” says Matt Nelson executive director of strategy at post-trade technology provider Omgeo.
“For money managers and for hedge fund managers, the cost of compliance can never improve the top line; it can never help you book in revenue.”
David Beatrix who works in business development at BNP Paribas Securities Services adds that the key metric is the number of additional activities that funds will have to go through under the new regulation.
Following the calamitous effect that the unregulated OTC credit derivatives market had on the global economy in 2008, in September 2009 the G20 countries agreed that standardised OTC derivative contracts should be traded on venues wherever appropriate, and would be cleared through central counterparties by the end of 2012, with trades reported to trade repositories.
Although well intended, the rules place a great deal of pressure on firms in the derivatives business as they move to the central clearing model, with increased volumes moving from bilateral to exchange traded.
Moving the margin
The margin requirements for centrally cleared trades are greater than for non-cleared bilateral trades. The margin imposed on bilateral trades is typically variation margin, which accounts for changes in the value of a contract as opposed to initial margin, which CCPs demand to mitigate counterparty risk. Typically initial margin requires high quality, highly liquid assets such as government bonds.
The International Swaps and Derivatives Association, found in its Margin Survey 2012 that 93% of all credit derivatives trades executed were subject to collateral arrangements during 2011, the highest rate observed among all different types of derivatives transactions.
Overall, 71% of all OTC derivatives transactions were subject to collateral agreements during this period. Cash represented around 79% of collateral received in 2011. When initial margin is required, the amount of assets can be expected to vary considerably.
“Firms have been used to collateral being the subject of bilateral negotiation between two counterparties,” says Anthony Belchambers, CEO of industry body the Futures and Options Association.
“As you move more OTC contracts into CCP clearing, those same counterparties will face increased margin calls because CCPs have to be as safe as possible on margin calls, they will be called more frequently, the assets they put up for collateral will have to pass a high-liquidity loss resistant test, making many of the assets they have used in the past no longer eligible as collateral.”
Previously, under bilateral agreements, firms would typically agree to ‘minimum transfer amounts’ to minimise the number of frequent, small payments being made to cover the variation margin which is adjusted daily, according to the changing value of the contract.
Firms might make payments every three days or every week to reduce the administrative costs, and although their portfolio might be in US dollars, euro and pound sterling, the agreement would often only require payment in one currency.
That will change, says Beatrix. “Margin calls will have to be paid in the underlying currency and the concept of the minimum transfer allowance does not exist anymore,” he said.
“Everyday your clearer is going to call you for every single penny owed, and you may have to instruct tens or hundreds of collateral calls. If you are an asset manager with 200 hedge funds the operational burden could be substantial.”
Custodians and prime brokers such will try to facilitate the process observes Belchambers, but there will still be frictional costs, “Banks will provide the sort of collateral that will be accepted using a collateral transformation process, but the costs could be high, particularly if the demand for that collateral exceeds supply.”
A global challenge
The principle of making OTC derivatives markets secure has spread beyond the G20; countries outside of the group with large active trading communities such as Singapore are adopting some of the G20 principles. In February 2012, the Monetary Authority of Singapore, the country's financial regulator, issued a consultation on plans to adopt central clearing and trade reporting.
Buy-side firms are already preparing for the effects of regulation; custodian bank BNY Mellon reports it has signed up two Singapore-based insurance fund in Asia Pacific to its Derivatives 360 offering, which assists with collateral management and derivatives valuation among other functions.
Chong Jin Leow, country executive and general manager of BNY Mellon's Singapore Branch BNY Mellon said, “We see a lot of potential for these services in Asia Pacific. One of the lessons from the global financial crisis is the importance of the ability to get consolidated portfolio information very quickly and accurately. So if you don’t have a good data management platform it will be difficult to get the consolidated information together very quickly.”
Leow says that the appeal for increased automation is found in the risk management department; back offices are not equipped to provide valuations more frequently that once a week or once a month.
“That is no longer acceptable,” he says. “If it is provided by us as a service provider, we mark-to-market and provide reports to our customers on a daily basis.”
The global nature of the business will throw up operational challenges in the contradictions between the drive for transparency and the legal boundaries that exist between nations and regions.
“If the hedge fund is regulated in Singapore, then the legislation of Singapore applies including the privacy rules,” says Beatrix.
“For example, if that firm enters into an interest rate swap with Macquarie in Australia, who declares the trade to an Australian repository, then it will have to say it dealt with ‘Entity X’ as the hedge fund will not want to be investigated by Australian Authorities for its exposure to Macquarie via the trade repository.”
Too high a price?
“All these changes, for everybody, will impact on their terms of business with customers; will have significant IT consequences and will take time, driving up the costs of accountants, lawyer and IT suppliers,” says Belchambers.
That could leave smaller firms struggling to meet the demands he adds, leading to a crunch in terms of service provision. This pressure is making firms question what they can and cannot retain as internal resources.
“It is a more difficult marketplace for hedge funds today because these regulatory changes are increasing costs,” says Nelson.
“There will be great traders who will come up with the next strategy that will generate good performance, but keeping the shop running is a more expensive proposition these days. I think we will see some hedge fund attrition as a result, with firms saying 'the cost of compliance, the cost of satisfying client requirements at this point, is not the best equation.’"
The actual costs are still beyond the grasp of many. There are gaps in understanding amongst market participants which need to be addressed, such as cross border reporting to trade repositories.
Beatrix says: “What we know is that this regulation is a good opportunity for lawyers and system vendors because there is a need to investigate the legislation and the operational complexities.”