Advent Software collaborated with HedgeWorld in early 2012 to survey financial services professionals on the topic of margin finance and collateral management. Responses to the online survey came from 115 financial institutions including hedge funds, funds of funds, and asset management firms. More on the survey can be found at the end of this report.
Once considered relatively straightforward aspects of fund management, margin and collateral management have become increasingly complex in recent years. The post-Lehman liquidity crisis caused many hedge funds and asset managers to re-evaluate counterparty risk and how they planned to deal with it. One way to mitigate risk was to expand the number of trading relationships, diversifying risks across a greater number of counterparties. The effectiveness of this approach in a crisis like 2008 has yet to be seen, but it has already succeeded in making it more complicated for fund managers to manage trading costs.
As the industry has continued to become more competitive, sceptical investors continue to worry about liquidity, transparency and costs, and the business continues to become more “institutionalized,” encouraged in part by the growing role of investment consultants. All of these factors add costs and whittle away at the bottom line of fund managers.
Changes to the regulatory environment further complicate matters. The move toward central clearing of OTC derivatives has several important implications. First is the fact that additional collateral will be required at a time when many balance sheets are still challenged. The resulting squeeze makes cost-effective collateral optimization imperative. The many fund managers who still rely on spread sheets will find the new environment poses significant challenges.
Another implication is the fact that many fund managers are likely to find themselves managing both their legacy bilateral book of trades in addition to daily collateral calls for their cleared book of swaps. This additional complexity may con – tribute to additional risk. It will almost certainly contribute to higher costs.
In an effort to understand how hedge funds and asset managers were dealing with all of these issues, Advent conducted its 2012 Margin and Collateral Management Survey. It found that:
• Hedge funds can spend 11 hours or more on margin and collateral management every month.
• Errors are commonly found on collateral statements, leading to additional costs related to validation and oversight. Almost 9 out of 10 firms report errors in their statements.
• Insufficient margin can lead to missed trades, potentially harming fund performance. Firms with missed trades reported an average of four in the past year.
• Large funds regularly deal with 12 or more counterparties, adding significant operational complexity.
• The frequency of margin calls has still not caught up to reality. As the world moves inexorably toward daily and intraday margining, most funds still report weekly margin calls.
• Margin cost management efforts are often rudimentary, relying on Excel spread sheets and manual intervention. Cost attribution is most often at the fund level.
• 7 out of 8 firms sweep excess margin into a custodian account. Some may not have the adequate systems in place to determine an appropriate buffer.
It was fairly common in the wake of the financial crisis for hedge funds to increase the number of prime brokers with whom they did business. This may or may not have been an effective way to manage risk. It almost certainly generated additional costs. More importantly, it allayed investor fears. In any event, the expanding numbers of relationships was unavoidable to some degree, caused by the increasingly competitive hedge fund industry and the growing number of unusual and exotic instruments being traded.
Today, many larger funds continue to find themselves dealing with an array of counterparties. Hedge funds responding to the survey say they have an average of almost five relationships with prime brokers and other OTC counterparties (see Fig.1).
Scale matters. Smaller funds with less than $1 billion of assets only have 2.7 counterparties on average. Those with more than $1 billion of assets say they have relationships with an average of 12.3 counterparties. This ranges up to 20 in some of the most extreme cases.
Margin Call Frequency
Daily or intra-day margin calls are not as frequent as one might expect. Weekly margin calls are common among many of the surveyed hedge funds, despite the fact that this is likely to prove inadequate as the industry moves toward central clearing of OTC instruments. Less frequent margin calls are likely to have been agreed upon as a way to reduce operational demands. But with daily changes in exposure remaining uncollateralized, less frequent margining potentially exposes firms to higher levels of risk.
However, there is no doubt that there is a trend toward more frequent margin calls (see Fig.2). More frequent margining is particularly noticeable for equities and swaps, with more than one in four respondents saying that margin calls are more frequent for these products than they were only six months previously.
Very few respondents report less frequent margin calls, and there is no meaningful difference in trends among different sized firms.
Some survey respondents pointed out that the frequency of their margin calls depended on the markets and counterparties involved. Setting these responses aside, 55% of hedge funds reported weekly margining (see Fig.3). While 36% said they have daily margin calls, the remaining 9% said they only had margin calls on a monthly basis.
Hedge funds are more likely to have frequent margin calls than other types of buy side firms.
The frequency of margin calls is correlated to size, with large funds much more likely to have daily margin calls. Small funds are more likely to have weekly margin calls.
A margin lock-up is a type of credit extended by prime brokers to their clients, including hedge funds. Lock-ups keep prime brokers from changing rates or collateral requirements. They can also obligate prime brokers to clear trades unless the terms of the agreement have been violated.
More than two thirds of the hedge funds responding to the survey report having margin lock-ups in place (see Fig.4). Most of these say they have one to three such agreements in place.
The number of lock-ups is correlated to fund size. Not only do larger fund have more prime brokerage relationships to potentially cover with this type of agreement, but they also bring more leverage to negotiations with counterparties. It is, on the other hand, not unusual for smaller funds to have no lock-up agreements in place.
There is no consensus on who is best positioned to manage collateral and margin calls within hedge funds and other asset management organizations. It is often seen as an operational role, but Chief Financial Officers are responsible almost as often (see Fig.5). It is not uncommon for investment professionals including portfolio managers and research directors to manage margin calls.
Margin and collateral management can be a resource-intensive activity. Data validation usually accounts for the most time taken, with hedge funds spending an average of almost four hours a month confirming margin and financing data (see Fig.6). One in five report that validation requires more than six hours per month.
Managing collateral across counterparties demands almost as much time, with hedge funds spending more than three hours a month on this activity. When the time spent managing asset allocation and discrepancies across counterparties are also accounted for, it becomes apparent that hedge funds spend an average of more than 11 hours a month on margin and collateral management, which if equated to a headcount could add up to 132 hours a year and at a salary of $500k could equal $35k per year.The resource intensiveness of margin and collateral management is positively correlated to assets under management. With more counterparties and more trades, it is unsurprising that larger funds ultimately spend more time on these activities.
Errors are not uncommon in collateral statements. Almost nine out of ten respondents report errors in their statements (see Fig.7). Mistakes are most commonly found in statements for equities and swaps, but FX statements are the most likely to contain “many” errors. The prevalence of erroneous collateral statements can almost certainly be attributed at least in part to a widespread lack of automation and the industry’s continued reliance on spread sheets.
Smaller firms are slightly more likely to report errors than larger ones. This may seem unlikely given the added complexity that often comes with scale. But lacking the leverage and buffer afforded by size, smaller firms are compelled to scrutinize collateral statements with extra diligence.
The high percentage of firms reporting errors should concern fund managers for several reasons. First is the fact that errors could potentially undermine their awareness of counterparty exposures. Furthermore, errors create intangible but very real costs to their businesses. Finally, errors can form a real barrier to scalability: Growth is considerably easier when counterparties can be added without automatically increasing operational risk.
Identifying and reengineering processes that lead to errors or otherwise generate operational drag can be difficult, which is why growing numbers of managers look to outsource collateral management or use a vendor-provided solution.
Missed trades are another type of cost that could potentially be mitigated or eliminated by better tools and management. Fewer than half of all respondents report missing trades, and missed trades are rarely reported by larger firms. But in a business where a single trade can make or break performance, one missed trade is too many.
When asked how many trading opportunities were missed as a result of insufficient margin excess, firms in the survey reported missing an average of 1.6 trades during the past year (see Fig.8). When firms without any missed trades are eliminated, the average number of missed trades climbs to almost four in the past year.
Given the errors and missed trades reported by survey respondents, it is all the more surprising that more is not being done to improve management of financing and borrowing costs. It isn’t that managers are doing nothing: Fewer than one in five says they do not actively manage these costs at all, and these are almost inevitably small funds.
Rather, it is how those costs are managed that raises questions about the efficacy of those efforts. Most firms continue to rely on spread sheets or proprietary systems to manage costs, with third- party solutions used only rarely (see Fig.9).
Hedge funds are less likely than other organizations to actively manage their financing costs, and those that do are more likely to rely on spread sheets, which are not necessarily capable of dealing with complex and more frequent collateral management.
The operational costs if left unchecked can be significant. Funds that are not managing their costs will probably want to start. Those using rudimentary tools may want to upgrade their approach.
Some fund managers will go to their prime brokers for technology. Some will look to solutions provided by technology vendors. Still others will prefer to develop proprietary solutions.
One common misstep when trying to manage financing costs is insufficient specificity when it comes to attributing costs. Among survey respondents, financing costs are most commonly attributed at a fund level (see Fig.10). Fund level attribution is especially prevalent among small firms. Hedge funds are even less likely than asset management firms to attribute costs at the trader level.
Attributing costs in a corporate setting is always fraught, but that alone is unlikely to explain the overwhelming lack of granular attribution in this case. The primary driver in this case is more likely to be the limitations imposed by inadequate resources or technology.
Excess margin can have a significant impact on financing costs. It is not so much whether excess margin is present, but whether or not it is dealt with proactively. Not sweeping excess margin is a missed opportunity that can ultimately harm the bottom line. What is done with excess funds is secondary. The issue is whether or not anything is being done.
Almost a third of all survey respondents say they sweep excess cash into money market products (see Fig.11). Almost half choose to hold onto a buffer while sweeping the remaining cash. How much to leave as a buffer is a tactical business decision that could be enhanced by the use of analytics and decision support tools.
Only one out of ten firms in the survey does nothing with their excess margin, but this rises to one out of five hedge funds. Large hedge funds are the least likely to put excess cash to productive use, with two out of five saying they leave the excess in an account.
It is clear from the survey results that typical margin and collat – eral management practices fall short. Inefficient processes, inadequate resourcing, and (in some cases) a lack of concern conspire to generate a bevy of costs that can harm the bottom line. The impact in some cases is too small to be overly worry – ing, but seemingly insignificant shortcomings could prove to be major stumbling blocks in a rapidly changing environment.
As competitive pressure mounts and regulatory initiatives take hold many financial institutions will need to overhaul their margin and collateral management practices in order to stay in the game. Ideally, this would happen in the context of efforts to establish enterprise-wide risk management. Short of that, there are still a number of tactical steps that the average hedge fund or asset management firm could take to improve their competitiveness.
It may represent a significant departure from the way they have done business in the past, but many fund managers will likely want to devote additional resources to optimizing collateral, especially as margin calls become more frequent. Systems and tools from prime brokers or technology vendors may also prove to be useful aids in their efforts to minimize errors, avoid missed trades, and accurately attribute costs. However they choose to tackle this particular issue, fund managers who preemptively address operational details are likely to benefit in a competitive environment where performance and client satisfaction are increasingly hard won.