OTC Derivatives

Reshaping how investors and managers work with service providers

Originally published in the September/October 2012 issue

In 2008, the financial sector was on the receiving end of 8,704 global regulatory changes. This figure has grown 25% year-on-year to 14,215 changes in 2011. The capital provisions and the ability to interpret, implement and manage this sea of change is bifurcating the hedge fund administration industry. The next two to three years will be extremely challenging for the industry as a wave of new regulations tests the resilience of hedge fund administrators and managers alike.

The US approach to G20 commitments has been one sweeping piece of legislation. The Dodd-Frank Wall Street Reform and Consumer and Protection Act, which runs to over 2,000 pages, aims to create more transparency in the derivatives space within the US financial system. In Europe, the approach to G20 commitments has taken a different path in that there are a number of regulatory initiatives dealing with different elements of the problem. When you combine the net effect of these changes you can begin to understand the quandary posed by 60 new pieces of financial regulation being issued per day throughout 2011.

A combination of the Dodd-Frank Act, the European Markets Infrastructure Regulation (EMIR) and Basel III will have a profound impact on the way in which over-the-counter (OTC) derivatives will need to be settled, collateralised and reported. Between 60-70% of all OTC derivatives will be required to be cleared centrally through central counterparties (CCP) following the implementation of Dodd-Frank between the fourth quarter of 2012 and first quarter of 2013. The impact of regulation – pure and simple – is that the cost of trading OTC derivatives has just increased.

The broad intention of global regulators was to push as many OTC derivatives into a clearing environment in order to increase transparency and reduce counterparty risk. The importance placed upon, and time spent, educating clients and market participants on what the marketplace will look like should not be underestimated or taken lightly. If, for example, you use a US prime broker and centrally clear your credit default swaps (CDS) and interest rate swaps (IRS), there will be an associated credit value adjustment (CVA) cost. This is a capital charge that forms part of a package of measures to mitigate counterparty credit risk written in Basel III.

The three key implications for hedge fund clients are: (1) Greater operational complexity with some derivatives being cleared bilaterally whilst others being required to be cleared centrally; (2) Significant increase in the demand for collateral for initial margin and finally (3) Limited availability of liquid, high-grade collateral due to other regulatory and capital adequacy reform requirements for the same high-grade collateral.

This will lead to hedge funds potentially having to optimise the collateral they post at the CCP – something they are currently not required to do with their prime broker. The US Office of the Comptroller of the Currency estimated that margin requirements could total as much as $2.56 trillion globally. For clients using OTC derivatives as part of their investment strategy, third party service providers can help them manage all, or part, of their derivatives operations.

Despite the delay in the final text for the Level 2 legislation of the Alternative Investment Fund Managers Directive (AIFMD) there has been no indication that the June 2013 deadline for implementation of the full package will change. The AIFMD introduces a number of new requirements to managers and fund administrators, which will set a precedent for UCITS V. Managers will be confronted, for the first time, with a regulated depositary role and will be looking to their custodian bank (assuming their administrator has one) to take on this role. The depositary has a duty to ensure that: (1) Cash flows are properly monitored and segregated; (2) Financial instruments are properly registered in segregated accounts and (3) There is oversight to monitor/verify the NAV calculation.

The main concern around having a depositary is the increase in fund operating costs. In addition, there is also concern that not many institutions will wish to be or can be depositaries given the strict liability in respect to the loss of financial assets that can be held in custody, which in itself brings into question the prime brokerage model used today for EU managers of European onshore structures from July 2013.

The duty of the depositary to oversee certain activities of the fund manager – including the oversight of the NAV calculation – has not receivedas much attention as the depositary liability issues. But it does still impact a London-based hedge fund manager with a Cayman fund who cannot benefit from a marketing passport in July 2013. The London-based fund manager can market their Cayman fund by way of a private placement, provided that it ensures that one or more entities carry out the depositary duties of cash monitoring, safekeeping and oversight and that there is a cooperation agreement in place between the competent authorities in the Cayman Islands and the European Securities and Markets Authority (ESMA). Furthermore, individual Member States may impose stricter rules on the London-based fund manager in respect of marketing units/shares of the Cayman fund to investors in their own territory.

As a recent Deloitte survey concluded (Responding to the new reality – Alternative Investment Fund Managers Directive Survey – July 2012): “Scale will be a clear advantage … Larger managers will be better placed to absorb these costs and are more likely to view operational realignment as a less daunting challenge.” As a result, managers are more focused than ever on managing their fixed and variable costs. Over the last few years, performance in general has not been as strong as market participants would have liked.

The costs and overheads associated with attracting new institutional investors and implementing operational and regulatory change have increased. Managers are looking at the core processes that they do well – asset management, investor servicing and marketing. As a result, they are looking to outsource as many of the non-core fixed costs as possible. These may include components of middle office outsourcing such as collateral management, the management of their CSAs, outsourcing of share class hedging, risk and performance reporting, cash management, and added portfolio transparency and regulatory reporting. Third party service providers are able to bring in a bespoke model to managers to effectively manage these costs and processes.

The necessity for managers to work with a strong counterparty and partner that can help mitigate operational and counterparty risk, as well as delivering the operational efficiencies required to meet the demands of both the regulated and unregulated funds market has never been more apparent or at the forefront of managers’ minds. The pace of consolidation in the administration space is evident and it is crucial to work with a partner that not only provides a long-term solution, but also understands and meets the challenges of the new dawn.

In terms of the regulatory impact, the full impact and extent of the current change agenda and the associated costs are not likely to be seen for several years. What is clear is that the cost of doing business and the cost of market entry have both increased. This could well be an impediment to new managers entering the market and attracting institutional flow, but it has also established a new, more transparent standard, by which to compare managers. Time and tide wait for no-one.

Marc Russell-Jones is a Managing Director, Worldwide Securities with J.P. Morgan. He has over 15 years’ experience in business development, sales and product management in European financial markets.