March 2011

I USED TO BE INDECISIVE, NOW I'M NOT SO SURE: the dilemma of the buy-side firms

IndecisiveRegulatory uncertainty is leaving many buy-side firms undecided on whether to participate in a reformed OTC derivatives market. Nicholas Pratt examines what the potential cost of this indecision could be Barely a day goes by without there being some announcement concerning the over-thecounter (OTC) derivatives market. These often opaque and complex instruments have been at the centre of capital market reforms and the efforts to create a more transparent and less risky investment environment, and 2011 is supposed to be the year that these changes take effect. But anyone who associates a daily flood of press releases, regulatory statements and company announcements with clear and consistent progress, would be sorely mistaken. The central tenet of OTC derivatives reform is the move towards central clearing and the use of a central counterparty (CCP) rather than the bi-lateral model that exists today. The logic is simple – the use of a CCP will bring more openness and less complexity in the structure of the derivatives contracts and it will also create a more efficient processing environment. And in some asset classes, such as credit default swaps, central clearing is already underway. In practice, however, there are still a huge number of outstanding issues to be resolved, particularly in Europe and especially for buyside firms – such as how far standardisation will extend; whether the new rules will be retrospective and require changes to existing derivatives contracts; which venues will act as CCPs; and how much will all this change cost the end investor. Buy-side firms essentially want to know whether or not the move to central clearing will make things better or worse – should they start making the operational changes needed or would they be better served spending their money on more cost-effective concerns? More worryingly perhaps is the fear that, while this uncertainty remains, a clear gap will develop between the buy-side and the sell-side dealers in terms of expertise and capability. Anecdotally, there is concern that many buyside investors have not spent the money that is needed on the infrastructural changes required to operate in a centrally cleared OTC derivatives market. The suspicion is that Excel spread sheets are still commonplace, few are connected to industry utilities such as MarkitServ and the Trade Information Warehouse, and many are unaware of the risk management measures used by broker-dealers, such as potential future exposure calculations. A more analytical study of this possible gap has been undertaken by research and advisory firm InteDelta which was commissioned by BNY Mellon to survey a number of asset managers, insurance companies and pension funds on their OTC derivatives operations and to investigate any evidence of a gap in capability between buy and sell-side dealers. The survey found that almost 40% of institutions do not have an internal OTC derivatives pricing capability. Only 10% of institutions use potential future exposure (PFE) calculations to measure their counterparty risk, and less than 25% of surveyed buy-side firms rehypothecate their securities collateral making it available for reuse. The implication of this gap is that there will be an increase in outsourcing and a reinvigoration of the prime brokerage model. Conveniently for the likes of BNY Mellon it has developed a business line to capitalise on this opportunity. “We have built products that will give buy-side firms access to the same technology and risk management tools that the sell-side dealers are using so that they can navigate the market on an equal footing,” says Stephen Ingle, head of derivatives product management at BNY Mellon. “It is too expensive for buy-side firms to keep up with the infrastructural and regulatory changes.” But is outsourcing a long-term solution? “Outsourcing is a long-term solution. Just look at what’s happened with custody – fund managers could do it themselves but they realise it is a volume-driven game where economies of scale are vitally important. The same will eventually happen with OTC derivatives where anything that could be considered vanilla investment management administration will be outsourced and just the front-office activity will remain with the fund managers. We are moving towards greater use of centralised operations through industry utilities.” Ingle mentions Trade Information Warehouse as one example. “The lifecycle of a credit default swap, from the calculations to the payment instructions, is automatically managed by an industry utility and this makes it easier for everyone. And the move to CCPs will only increase this.” The conclusion drawn by many observers is that the CCP model will make interest rate swaps enormously expensive. Rules such as segregation of initial margin at the clearing house level will make transaction fees from brokers massively expensive. This will be offset somewhat by an increase in transparency and a lower execution cost but ultimately the noticeable change will be the prohibitive fees. Whether these fees will make OTC derivatives too expensive for many fund managers and other buy-side competitors is a difficult one to answer, says Thomas Deppe, global head of corporate risk advisory in Germany at Commerzbank. “There will be a cost in terms of operational changes but there will also be a tightening of spreads and reduced pricing as a result of central clearing so it all depends whether the impact of spread compression will outweigh the cost of operational change.” Buy-side firms will have to ensure several things are in place to operate in a centrally cleared OTC derivatives market – such as effective documentation (a CSA and Isda contract), independent pricing, counterparty risk reporting and collateral management. Many of the larger buy-side firms will have such measures in place but this is not the case for the smaller asset managers. It is also unlikely that they will have the money to invest in these resources. “What is possible is that these firms will return to investing in more traditional areas such as cash, bonds and equity funds,” he adds. All the reform in the OTC derivatives market will come at a cost and whether that cost will be passed to the end-users and, if so, how much will depend on how much business the buy-side will be able to send to their sell-side counterparts, says Deppe. “All this remains to be seen but until then it is very hard for us to give any quantification around the cost of any services that could be offered.” This uncertainty extends to a whole range of potential services, the costs of which are currently unknown. “For example, buy-side firms that opt for centrally cleared OTC derivatives will have to provide central counterparty (CCP) margining by pledging initial margin and variation margin and controlling both. This is something that could be taken on by banks but we don’t know what the required margining levels will be and therefore cannot tell what the effective cost of providing this service will be,” he adds. “There is still a lot of uncertainty about what outsourcing services will be offered to the buy-side and who will be offering them,” says David Campbell, senior product manager, Fiserv Investment services. “Will a single direct clearing member be able to provide all the services needed or will buy-side firms have to have several relationships? Will asset servicing banks have to be involved as well to provide more of the processes needed? Will there be some sort of industry middleware created to make it easier for everyone?” Some of the largest asset managers will choose to do all this work themselves, to lessen the operational risk of contracting external parties but many others will choose to outsource. And while outsourcing will be cheaper, it will not be free. A third option is to walk away from the OTC market altogether should the operating costs of such instruments outweigh the trading benefits on offer. But how likely is such a boycott? “I’ve not heard anything about asset managers not investing in these instruments but such a move would depend on finding alternative instruments such as exchange traded derivatives, which are attracting a lot more interest from the buy-side,” says Campbell. The other possibility is that buy-side managers start to gravitate towards more complex OTC derivatives that cannot be standardised and therefore avoid the costs of central clearing. Such a move would, of course, go against everything the regulators have tried to instil – greater counterparty risk management, more transparency and more standardisation. But most buy-side firms do not have the expertise or systems to quickly and correctly value these contracts and to properly negotiate a contract and would have to buy in that expertise. “No matter what direction the regulator goes, it will be costly to the buy-side,” says Campbell. The question then is whether they choose to spend their money on the front office in getting in valuation expertise or on the back and middle office in terms of connecting to the various CCPs. “Fund managers have some decisions to make,” says Dick Severs, senior buy-side consultant at Pacemetrics, a vendor of data management services. “Do they focus on getting more expert staff and continue to deal in the more exotic derivatives in order to generate alpha and adopt a policy of spending money to make money? Or do they concentrate on improving their back office processes in line with the demands of central clearing and create an environment that is better able to efficiently process a higher volume of transactions – albeit it involving more commoditised  instruments with much lower margins and a much lower prospect of a return?” ©2011 funds europe

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