The system requirements of new derivatives rules will likely increase asset managers' reliance on service providers. Nicholas Pratt examines what managers should be looking for in a potential provider.
A new era of derivatives dealing is upon us. The Dodd Frank rule in the US mandates central clearing and trade repository reporting for interest rate swaps and credit default swaps, while the European Market Infrastructure Regulation (Emir) will introduce the same requirements in Europe before the year end, according to the most recent regulatory update.
For asset managers with any derivatives activity, there are several changes to be made. Fortunately, there is a long list of service providers lining up to offer assistance at this time of need.
The most immediate requirement for asset managers is to find a provider willing to offer them connectivity to central counterparties (CCPs) and clearing houses – a gap that asset servicers are looking to fill.
For example, France-based Caceis is offering over-the-counter (OTC) clearing services – processing, reconciliations, collateral management and net margining – but it is not, as yet, a direct clearing member of the various CCPs offering derivatives clearing for OTCs, unlike some other asset servicers.
“There are two or three major players that have direct membership and are trying to offer global clearing services but they have issues doing the net margining because the portfolios in OTC and listed instruments are not always balanced in terms of long and short-term outlook,” says Hubert Montcoudiol, head of clearing services at Caceis.
“So we are pragmatic about direct membership for OTCs. We are a strong supporter of the need to standardise OTC derivatives but our clients are telling us that direct membership is not necessary at the moment. In the coming months, we will look closely at the impact of the new regulations in line with our clients’ needs.”
Beyond clearing, collateral management is one of the most pressing areas facing asset managers. The new collateral requirements from central counterparties (CCPs) will require a greater quality of collateral than was the case in previous bilateral arrangements.
“In the past, some asset managers were large enough to only post margin once a week or even just once a month; they could dictate their own margin terms and now they are having those terms dictated to them,” says Ben Broadley, solution manager at Advent Software.
Once the plumbing challenge of getting trades affirmed and confirmed has been met, managers will then be looking to add more efficiency into the collateral process. “If you are smart about the pre-trade, you can reduce your burden in the post-trade,” says Broadley.
“If the front and back office communicate, if you know where you are going to clear trades then you can tell what the impact will be in terms of margin calculations,” he adds.
On the post-trade side, managers will initially be relying on third parties to manage the margin and collateral burden and ensure there are no compliance nightmares. But as they get more familiar with the new rules, they will bring that in-house and be more reliant on independent software vendors to provide the technology.
“This is part of the challenge for software providers – to get from sufficiency to efficiency – but it will not just be a case of getting from A to B in one big leap. It is likely to be iterative so the platforms have to be flexible.”
It is not just the extent of work that will make managers more inclined to consider help from third parties, it is also the unpredictability, says Broadley.
Some funds have traditionally built these platforms in-house, but now they want things that are future-proofed. “With all the uncertainty around regulations and rules, system development can be a leap into the unknown and they want a vendor to take that on.”
A related area in which investment managers will have to take a more proactive approach is margin requirement, whereby derivatives participants will need to post margin to cover both past and potential valuation charges, says Christopher Finger, executive director of applied research at MSCI, a provider of investment tools. “Central clearing represents an exchange of credit risk for liquidity risk and at the heart of this exchange is margin,” he says.
“Investment managers have to be able to know which clearing broker offers the most efficiency in terms of the least margin and the most diversification or off-setting with other trades. They also have to be more forward-looking by assessing not just the initial margin but what margin will be required in the future as a result of rate changes or new market moves. So an element of stress testing will be required.”
Some dealers are providing such a service through client portals – an option that is likely to be appealing for investment managers with a relatively small derivatives business that is conducted through a single broker. For the larger and more sophisticated asset managers and hedge funds, outsourcing to a specialist may be the preferred option, says Finger.
However, the idea that outsourcing derivatives processes will be cheaper and simpler for asset managers is as yet unproven, says Steve Young, chief executive at Citisoft. “Asset managers see this as a niche area and are looking to use specialist providers but it is questionable whether there will be any wider efficiency,” he says.
For example, the addition of a new collateral management system still creates workflow issues and managing multiple CCP relationships means managing multiple interfaces.
Of course if managers could find a full service provider to take on all of its OTC derivatives processing needs, then these problems would be for the outsourcer to solve rather than the manager but collateral management and other derivatives-related services are still seen as largely specialist functions requiring bespoke systems from niche providers.
And these new specialist systems combined with the old in-house technology create sizeable integration issues for managers and guarantees that some manual intervention will be needed at some point in the derivatives lifecycle, says Young.
The full service providers have the benefit of established relationships, scale and balance sheets but not all have invested in the technology or the expertise needed for derivatives. And for the specialist providers the challenge is to prove that they have sufficient scale – something that many managers are neglecting when assessing potential providers, says Young.
“There has been too much focus on functionality. Scalability and cultural fit are just as important. Managers have to take a very careful and mature look at outsourcing. If the service provider can’t provide exactly what is needed then managers will need to put in internal buffers to fill these gaps and that will only make the integration issues more complex.”
The need for more thorough due diligence is especially hard for asset managers given that they don’t have the expertise needed to assess these providers and will therefore have to rely on consultants’ help.
Plus, the derivatives market is so fast-moving that the requirements and capabilities are constantly changing. Things will get easier in time as the regulations become clearer, the instruments become more standardised and the technology improves. But in the immediate short-term, asset managers must brace themselves to deal with the difficult time ahead, says Young. “They must acknowledge where they have genuine gaps, fix them and move on rather than papering over them.”
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