The development of the credit risk market is a major reason for the rapid increase in the popularity of capital structure arbitrage and other credit strategies. A Fitch Global Credit Derivative Survey, published in January 2005, showed that the credit derivatives market expanded to $2.8 trillion of gross sold outstanding, or $3 trillion, including cash collateralized debt obligations (CDOs), an increase of 71% from $1.7 trillion ($1.8 trillion including cash CDOs) last year. Hedge fund activity grew substantially year-over-year and now comprises a sizable percentage of credit derivatives volume (20%-30%).
There are many major problems and issues related to entering the Capital Structure Arbitrage or credit-based business. In the realm of administrator relationships, the very nature of OTC contracts, trading physically versus electronically, and the lack of automation in clearance and settlement as well as payment processing, puts tremendous pressure on manager's middle office staff. Even with the presence of an administrator the manager should expect to own 85%-95% of this process.
Inevitably, a manager who may currently outsource back office functions to an administrator will, over time, re-internalize administrative operations. Because of administrator inability to adequately service such a complex strategy, the manager will slowly over time, build in by necessity, operating capacity to make up for administrator short comings. After a certain point, manager capability outpaces that of the administrator and the relationship is terminated. Carbon360 has also found instances where the administrator failure is far less gradual, and a more immediate termination has occurred. In several situations, it was actually the administrator that fired the manager.
Carbon360 interviewed several leading U.S.-based credit fund managers, one in particular was an approximately $1.3 billion distressed debt fund whose book of business is almost 80% physically settling. Trading volumes over fiscal 2004 were 113 purchases and 66 sales for primary and secondary market paper only. They employ a compliment of nine FTE's to support trading operations. The designated roles and headcount are as follows (2) Loan Admin/Closer, (2) Para-legal, (1) Liquidity/Collateral Management, (2) Controllers, (1) Fund Accountant, and (1) Trade Support.
The problem inherent to all is simply a lack of qualified personnel, which is compound by extremely strong demand for qualified individuals, as a result in the surging use of OTC Derivatives and Loan products. This clear imbalance between supply and demand has sharply driven up the price tag of the available talent. Where as ISDA reported as of 2003, that the average annual salary was $58,000, Carbon360 spoke with several executive recruiters and found the median salary now to be $85,000. That's an increase of 46.5% in just two years. Based upon this and the expectation that at least 9 FTE's with specific skill sets are required for a book $1 to 2 billion in size, that's an addition to the payroll of at least $765,000, not including bonuses.
There are also numerous operational issues to contend with. Carbon360 found that nine out of ten managers who have entered the Capital Structure Arbitrage business have done so before building adequate infrastructure. This has typically resulted in several quarters' worth of undue undo operational pain.
Collateral management becomes imperative because both assets and cash secure contracts. Proper processing of dividend, interest and corporate actions becomes complicated as assets sit in agent accounts, technically off-balance-sheet. Improperly drafted wires, and poor booking and reconciliation of assets, disrupt the street to cash movement process, resulting in NAV latency.
Further, Carbon360 found that many managers of pension assets are actually in violation of Erisa requirements. If the fund has Erisa money, it must distinguish the percentage of beneficial ownership down to the asset level and track any Erisa assets used as collateral, (Erisa Act of 1974) and notify the counterparty at the time of contract initiation. Hedge funds that invest across the capital structure, including bank debt and public securities, are likely to come under increased scrutiny when the Securities and ExchangeCommission requires them to become registered investment advisers next year.
Cash and margin management often suffer as managers fail to properly address the reserve tracking versus committed capital requirements, improper reconciliation of nostro accounts, and poor cash transfer logging procedures. NAV latency, restatements and limited transparency into top and bottom lying credit exposures are to be expected.
Balance sheet and trial balance irregularities are quite normal. All too often payments are made and received between parties for contracts that are either unconfirmed or non-existent (i.e. perhaps with between another protection writer or counterparty), or not made when they should have been, or accrual balances are inaccurately calculated resulting in frequent debit and credit shifts. During our research Carbon360 found both writer and counterparty susceptible to this problem.
Counterparty issues are also numerous and complex. Writing contracts against hard-to-borrow short positions, illiquid securities or over other over the counter ("OTC") OTC contracts such as "Swaptions" creates more complex collateral management, in terms of monitoring and settlement processes in proportion to the number of such contracts.
Settlement risk is exacerbated by incredibly long settlement cycles on almost all OTC and Loan products. Increasing confirmation failure rates and a general inability of both manager and counterparty to effectively communicate the details of the trades has prompted several recent regulatory warnings. the most notable, coming from the Financial Services Authority ("FSA") in a general warning (March 29, 2005) whereby they stated; "The FSA requires all regulated firms to have in place appropriate systems and controls to enable them to ensure the smooth running of their businesses and maintain efficient, orderly and fair markets." They further added, "recent supervisory work has found that a number of firms in the fast developing OTC credit derivatives market are failing to resource their back office functions adequately to allow them to keep pace with the growth of their front office business."
Loan businesses, whether par or distressed, primary or secondary market, are suffering an even worse backlog in confirmations and extraordinarily long settlements. Regulations currently mandate that Par paper settles T+10, while distressed need settle on a T+20. However, that in reality things is quite different. Per Carbon360's conversations with several large Capital Structure Arbitrage and Distressed Debt funds, it has been found that average settlements running at T+ 17 for Par paper and a very scary T+ 65 on distressed.
Market makers in swaps don't always have a firm grip on correct pricing. Credit default swaps are very hard to price, because they're abstracting away from a normal corporate bond, or some other credit instrument, just the pure credit risk. One senior industry insider recently stated, "risk models provide a bell-shaped curve of probability distributions based on the past". If a company such as GM has never defaulted, "you can't put a probability on it". This insider further elaborated by saying "one systemic fear is that our core banks and brokers are meeting their capital requirements by moving their credit exposure into unregulated funds that don't have capital requirements."
Further, as of late many credit hedge funds report dealers are increasing margin call frequency in the wake of recent mark-to-market losses on collateralized debt obligation trades. One fund manager said this is adding to the pressure on funds, which are also facing dealers unwilling to provide liquidity in the structured credit market. Dealers said this is because they have already reached risk limits for volumes of cash collateralized debt obligations (CDOs), CDO equity tranches they can hold and hedge.
Contrary to the findings in a recent International Swaps and Derivatives Association ("ISDA") survey, automation of operational functions has not improved. The timely dispatch of confirmations continues to present a challenge for virtual all counterparties, with ISDA even reporting that transaction complexity remains the chief contributor to the issue. ISDA further elaborated, that counterparties generally had problems with confirmations for new product types and confirmations requiring tailored language typically took longer to produce.
Table 1 shows the error rates associated with traders entering erroneous data into deal tickets according a recent ISDA Survey on Operations. The error rates for credit derivatives are high relative to those for other products for all firms. One possible explanation is that firms are more likely to enter into multiple trades on the same reference entity, which presents more opportunity for repeat errors. Another explanation is increased attention to data integrity particularly with regard to the reference obligation, reported by some ISDA member firms over the past year. That is, higher standards lead to more scrutiny, which in turn leads to higher reported error rates.
Chart 2 shows the relative frequencies of trade details the front office gets wrong for credit derivatives. The most common errors involve dates (trade, settlement, and so on), trade conventions, and some aspect of counterparty details. Credit derivatives appear more vulnerable to errors in trade details – reference entity and reference obligation details in particular – and less to errors in trade conventions.
Our research also revealed that the further adoption of FpML is reported to be held back by uncertainty regarding the technology and competencies needed to implement FpML. Though volumes across the three main matching services; DTCC Deriv/Serv, SwapsWire, and MarketAxess continue to increase, the services continue to suffer low adoption rates among buyside firms, especially hedge funds who are the primary writers of Credit Default Swap and other OTC contracts. This is a least a favorable move in the right direction considering there is not messaging protocol even under development for primary market distressed debt.
In conclusion, while the near-term potential for profits remains attractive, the operational hurdles and issues to starting and running this business strategy are numerous and costly. Hedge fund managers should fully comprehend the issues at hand, and be ready to commit sufficient resources to cope with them, before initiating a Capital Structure Arbitrage or other credit strategy business.