July 2008

OTC DERIVATIVES: Pushing Up Daisies

The focus on counterparty risk in the OTC derivatives market is starting to gain importance after the Bear Stearns episode, but only slowly. Nicholas Pratt looks at how the industry is adjusting The sharp growth in over-the-counter (OTC) derivatives – particularly credit default swaps (CDSs) which are meant to offer insurance to investors against companies that fail on their corporate bond payments – has resulted in long and complicated chains of interlinked trades between fund managers, banks and hedge funds. Mike Goldfinch, senior consultant at fund management consultancy Citisoft, calls these “daisy chains”. When a fund manager purchases a CDS from a bank to insure against another entity’s bond defaults, it is likely that this same bank has bought similar protection elsewhere from another organisation. Often these instruments are traded rather than kept by one owner as an insurance policy, so the chain gets longer and longer.

“This can lead to a daisy-chain of derivatives, all of which are linked, albeit not explicitly, and as this chain gets longer, the counterparties at either end remain unaware of the existence of each other,” says Goldfinch.

The trouble with daisy chains is their fragility. When Bear Stearns, the bank, collapsed during the sub-prime crisis, it was feared a number of other hedge funds and banks that acted as counterparties somewhere within Bear’s derivatives positions would go the same way and end up pushing up daisies rather than making them.

The whole episode brought to light the issue of counterparty risk within these opaque OTC markets. But it appears that relatively little so far has been done by asset managers to tackle the risks that unknown, and sometimes weak, counterparties pose.

“Every fund manager will have its own way of monitoring counterparty exposure, generally based on limits management, and so far I have seen no evidence of these limits changing drastically,” says Goldfinch.

The dominant factor in the selection of counterparties – particularly in the post-MiFID era of best execution – remains cost. Provided that they are within their compliance limits, fund managers will go with the counterparty offering the best price.

“There is an opportunity for them to look more closely at their counterparties but I don’t think many of them are actually doing that at the moment,” says Goldfinch. “I think it will happen but it will happen very slowly,” he adds. “Fund managers are not stupid and everyone is aware that this is an issue but it is just that other issues have taken their attention.”

Big risk
Those other issues must be pretty big to distract fund mangers from counterparty risk. The CDS industry alone is worth $58 trillion and hedge funds are 30% of the entire OTC credit derivatives market. Yet they are not required to post any information about their capital adequacy, while no counterparties at all are required to reveal who else they may have sold the same derivative contract to.

Both of these issues conspire to make it harder to assess whether an explicit counterparty will be able to pay out should the derivative contract mature.

However, Elias Nachachby, vice president at financial technology vendor SunGard Asset Arena, says that although current market practice does not have the integrity that it should have, there is more evidence of a prescriptive best practice emerging.

The first element is a new approach to valuation models used for credit derivatives and an inclusion of the clear correlation that exists between the probability of default for the counterparty and the reference entity.

“For example, if one financial institution is selling protection on another financial institution, this is valued the same way as if the correlation between the two parties is zero, which is clearly not the case,” says Nachachby.

The second element is the mandatory use of collateral in every derivative contract – something that has been widely recognised by many of the asset servicing firms, particularly those that offer a third-party collateral management services to fund managers.

“Collateral has been a key tool in managing counterparty risk for many years but I think there has been a key change in the last six months,” says Mark Higgins, head of marketing and sales EMEA for BNY Mellon’s Global Collateral Management Services.

Prior to the Bear Stearns episode and the awareness that counterparty risk may be a source of peril, many organisations saw collateral as a means to a more lucrative end and were looking to expand their rules of collateral eligibility, reduce thresholds, get in more collateral and offset them against regulatory requirements, says Higgins. “But what I have been hearing is that in the last six months there has been a return to the traditional approach to collateral: manage what is in your own backyard and worry about the risks that are in front of you as a matter of priority.”

Tightening of rules
This means making sure that margin calls are done within the stated time-limits and that any disputes are presciently investigated and resolved rather than neglected for days.

“We are seeing a tightening of the internal rules applied to each counterparty,” says Higgins.

However when collateral is applied to an OTC derivatives portfolio, this will bring its own inherent risks. While it may be used to offset counterparty risk in a credit sense, it also creates its own operational risks, something that now has to be factored into any assessments of potential counterparties, says Higgins. Additional operational measures include the processing and administration of these contracts. Upgrading in-house software and connecting to industry resources like the Depository Trust and Clearing Corporation’s DerivServ would help standardise contracts and improve the level of information on counterparties. Equally, greater use of post and pre-trade compliance checks would have a similar benefit.

Making collateral a mandatory requirement and stressing the need for a new valuation framework and upgraded software will all have financial implications for fund managers. “There is an obvious cost to quality but there is also an advantage,” says Nechachby. “It is essentially a balancing act – a short term cost against a long-term loss – and when this risk is large enough, the cost of mitigating against that loss is far less than the cost of the loss itself.”

Justifying costs
For some fund managers, those that have been active in the derivatives market for a long time and have been trading significant volume, this point has already been reached. But for those firms that are only in their initial stages of derivatives trading and enjoy more modest volumes, it is harder to justify the investment in proper risk management, collateral management and compliance processes.

The concern over collateral has led to an increase in the number of support credit annexes – agreements regarding the posting of collateral – requested in OTC derivatives contracts, says Higgins. These can become very labour-intensive for smaller buy-side firms. “If you are a new firm with a handful of credit support annexes in place but wanting to step up the level of OTC derivatives activity, you have to ask yourself if you are capable of administering these agreements, capable of meeting the daily margin calls,  and capable of managing any collateral that comes in. The larger players will handle this in-house but they may begin to ask questions of their smaller potential counterparties and whether they can handle this process.”  

Technology gap
The need for greater levels of collateral management and automated processing is not helped by the fact that the technology and resources available for counterparty risk management are still relatively immature and inaccessible to those outside of the top tier of the market. “There has been an evolution among the larger banks in managing their counterparty risk exposure – from the static, binary methods used in credit risk to the more dynamic aspects of market risk – but outside of these top tier players, it has proved harder for smaller buy-side fund managers,” says Rohan Douglas, CEO of Quantifi, a provider of risk analytics and models for credit derivatives. “The types of models that can measure this kind of counterparty risk for complex OTC derivatives are relatively bleeding edge and the leading banks have spent a lot of money on developing this software on a proprietary basis.”

So, counterparty exposure is likely to be an area of increasing focus for fund managers, particularly if the revelations of billion-dollar losses continue to emerge from the collapse of the sub-prime market. As SunGard’s Nechachby says: “Events are a reminder. When there is a positive P&L, this can tend to be the primary focus for firms but when negative events happen around them and happen to a large player, then they start to think that it could happen to them as well and it is then that they react.” ©  2008 funds europe

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