If you can’t beat ‘em…
surge in demand for high-quality assets that can be used as collateral for cleared OTC
derivatives following the introduction of new regulation will require buy-side
firms to adopt a sell-side-like mentality, according to Sarah-Jane Dennis,
consultant, Investit, an investment management advisory firm.
“The collateral demands that
institutional investors face will be huge and require the buy-side to improve
technology, data collection and analysis, and their overall skillset to manage
this effectively,” she says. “Many asset managers are likely to depend on their
brokers, but larger firms may want to exercise more control and take only
limited services from their clearing member.”
New rules that
will come into force from the start of 2013 in Europe and the US will push a
large chunk of the OTC derivatives market through central clearing, having previously
been traded and managed directly between two counterparts. Contracts that can
be standardised will also be traded on exchange-like platforms and all swaps
trades will be subject to more detailed reporting requirements.
From a collateral
perspective, this means the buy-side will have to develop more formal processes
for managing margin payments, which will require them to meet calls in a more
timely manner and spend more money to ensure positions are adequately
“The buy-side will move to a
world where a CCP demands initial margin – something it has not historically
paid – and calls on variation margin at least seven times a day,” says Dennis.
“Investors will also need to contribute to a default fund to protect against
fall-out if other parties default.”
The buy-side has
the option to use clearing members as a conduit for fulfilling these duties by
hiving off a certain portion of their funds’ assets that can be managed by the
clearing member for collateral purposes.
Front of mind
But as the new
swaps regulations begin to settle, the impact of the collateral burden on fund
performance could lead the buy-side to take more control.
“The management, or at least
oversight, of collateral will become more of a front-office type investment
decision, having previously been an administrative-heavy back office function,”
says Dennis. “Some of the larger buy-side firms may prefer to take matters into
their own hands and build up their skillsets internally rather than relying on
close relationships with their clearing members.”
The level of
control a buy-side firm chooses to exercise will also be reflected in the
segregation options they choose. Under both US and Europe regulation, clearing
houses need to offer the buy-side the option to segregate their assets from
other entities, so that the collateral they hold at the clearing house is
protected in the event of a default.
The two options open to the
buy-side in Europe are an omnibus account – with exposures of all a clearing
member’s clients consolidated, offering netting advantages – or individual
segregation, which separates the exposures of each buy-side firm but limits the
opportunity for cutting margin costs through netting.
“Whether a buy-side firm opts
for segregated or omnibus account structures will come down to balancing the
costs against the risks,” says Dennis. “Buy-side firms are cognisant of the
fact that under the omnibus structure, collateral held at the clearing member
will take time to be released, even if careful ownership records are kept by
the clearing member and therefore cannot be rapidly transferred to another
entity in the event of a significant problem with the clearing member.”