Nicholas Pratt talks to fund managers and asset servicers to see what changes to complex OTC derivatives will have been made by the time they come back into fashion...
How things have changed in two years. In the run-up to Christmas 2007, top of the toy charts was a battery-operated dog that grows bigger the more you talk to it. Fast forward to 2009 and the most in-demand present is an artificially intelligent hamster. Fashion can be so fickle.
It is a similar tale for institutional investors. Over the last few years there was an insatiable appetite for complex structured products, despite the various warnings sounded by respectable figures such as Warren Buffett who likened credit derivatives to weapons of mass destruction and cited age-old investing maxims such as ‘do not invest in instruments you don’t understand’.
But ever since Lehman Brothers defaulted, the scales have fallen from investors’ eyes and complex, structured over-the-counter (OTC) products have fallen from favour. “We have seen a volume decline of roughly 20% in terms of highly complex structured products,” says Steve Ingle, derivatives product manager at BNY Mellon. “Although fund managers are attempting to raise additional capital by designing ever more creative and complex investment products, they are feeling limited by the impending regulatory changes that may increase the cost of offering these products. As such, they are not getting much buy-in from institutional investors who are more interested in the vanilla derivatives, such as those that are expected to adopt central clearing.”
According to the fund managers though, the change in attitude is more dramatic. “There was a voracious appetite for these instruments three to four years ago,” says Carl James, global head of dealing at Fortis Investments. “But some of the investors were quite badly bitten in the financial crisis and now they want products they can understand.” On the buy-side a lot of it was about keeping up with the Jones’s and having to find alpha somewhere, says James. Meanwhile the investment banks were pushing these structures down the throat of fund managers who would then try and sell them to clients without fully understanding the risks. But no longer, says James. “The tap has been turned off completely – no investor wants anything to do with structured products.”
And what of the risks involved? According to Lucia Southam, head of credit risk at Fortis Investments, the biggest challenge with structured products has been emotional economics. An extended bull run led to complacency with investors thinking there would be no default. “The quantitative analysts in the investment banks that were creating the products were not being challenged or asked to explain the risks by their own banks,” says Southam. “So by the time the products were sold to the fund managers, who are not as geared up as the banks in terms of risk management, it was all too easy to be trusting and complacent.”
The overemphasis on quantitative approaches led to a reluctance to think about credit risk the old-fashioned way and to ask the only two questions that matter – how will I get my money back and when will I get my money back? But, says Southam, these two questions were seldom posed during the boom years.
Of course things could not be more different now. Regulators are seemingly aiming to push complex derivatives to the periphery of the market – more under-the-counter than over-the-counter – and bring in central counterparty clearing for as many derivatives as possible. Meanwhile, investors are much more aware of the potential risks that could be involved with complex instruments and are also aware of the limitations of their own risk management capability, says Philippe Rozental, head of asset servicing at Société Générale Securities Services. “In many cases clients do not think they have the right tools to monitor the risk, calculate the right valuations or manage the collateral that comes with complex OTC products so they are less confident about using them.”
This lack of understanding within investing institutions has led to some unseemly recriminations in the aftermath of the crisis. Rozental points to the example of a French municipality that lost €30m from a structured product and then sued the bank that had sold them the product. “This raises the question of responsibility and where it lies: within the bank, for selling complex products, or with the client, for buying a product it didn’t understand?”
One option for institutional investors would be to embark on an education drive and increase their understanding of structured derivatives but, says Rozental, this is unlikely. Instead they should be seeking partners or providers that do have the expertise needed and can help them monitor the positions and challenge the valuations offered by the banks. “It is more efficient in terms of times and costs to choose a partner to work with rather than trying to teach yourself and playing the role of a sorcerer’s apprentice,” says Rozental.
Rozental’s view is supported by Geoff Harries, senior vice president, product strategy, investment services, at Fiserv – another service provider more than willing to help institutional investors and hedge fund managers plug any gaps they have in their knowledge and operational capabilities in the structured products world. “There is a very small skill set within a lot of hedge funds. Internal training is very difficult to do and recruitment is also very challenging because there is so much competition for good candidates. So I can see the outsourcing of knowledge and expertise increasing.”
Harries says that a number of buy-side firms were on the brink of beefing up their in-house infrastructure for dealing in the OTC derivatives market back in 2007 but put these plans on hold when the crisis occurred. “They are now in a ‘wait and see’ mode until the regulations are clearer and a clear plan around central counterpaties takes shape because no-one wants to back the wrong horse. However, once the new landscape is clear, then I think firms will return to their plans to invest and, when this happens, I think more will look to use an outside outsourcing provider rather than to do this all in-house because of the increased operational overheads.”
One of these operational overheads is the need for a more robust valuations process, something that became apparent in the immediate post-crisis aftermath as fund managers frantically tried to close out the positions on any potentially toxic structured product they held. According to Fortis Investment’s James, it was a process that involved a number of “difficult conversations” with portfolio mangers regarding the value of these products given the fact that many of them had been overvalued and were now subject to the fluctuating fortunes of an overly volatile market. For example, a fund manager may have been quoted a figure two weeks prior but in that time the market has been moving so quickly that the valuation no longer holds.
“The fact that most portfolio managers are paid according to the value of their portfolios, means this becomes an emotional issue,” says James.
In order to negate the emotional side, Fortis Investments, like many other investment managers, has its own reporting group that is separate from the investment division. When pricing these products there may not be a bid in the market, in which case it is valued from the bottom up and some assumptions have to be made but these assumptions have to be accepted by the portfolio managers. Now, a year later, people are taking a more sanguine view regarding these instruments and are willing to take a more long-term perspective, says Southam. But despite the fact that volatility is settling, pricing challenges still remain, particularly for any credit-related instruments where liquidity is scant and major defaults are still likely.
The other major change has been a more disciplined approach to counterparty risk. For example, asset managers are now establishing counterparty committees to rate the creditworthiness and performance of their counterparties and are also advertising for credit officers. “This is something I have never seen before and I think it shows how seriously they are taking the issue of counterparty risk,” says Southam.
However, Southam does not believe this will lead to a credit-scoring approach for the derivatives market, given the complexity of the instruments. Instead, there should be a return to first principles. “It’s about going back to basics and not being blinded by quant methodology but asking basic and direct questions – when and how am I going to get my money back?”
The rhetoric suggests that investors will not be so easily fooled again, even if the likes of BNY Mellon’s Ingle are keen to stress that not every market participant was wildly speculating in the OTC market and now feels cheated. Nevertheless, now that the appetite for these complex instruments has waned, is there a sense of relief for those working on the buy-side?
“From an intellectual perspective, these kind of products are quite fun,” says James. “But in terms of delivering value to clients, I’m very happy that they’re gone, for now anyway. They’re considered toxic.”
©2009 Funds Europe