Money managers and banks must be more efficient in using collateral for swaps, as new clearing regulations will require far more assets to be placed with central counterparties — to the tune of a combined $2 trillion, according to a report from TABB Group.
“These are new costs that come from” the Dodd-Frank Wall Street Reform and Consumer Protection Act, said Will Rhode, New York-based director, fixed income, at TABB and co-author with analyst Sol Steinberg of the report, “Margin Call: New Risk Tools for the Buy Side.”
The $2 trillion is far above what's being placed now; Mr. Rhode estimated that $100 billion will need to be posted this year.
“Capital is a scarce resource that cannot be squandered by overestimating a margin call. Efficient collateral use will become an integral, growing factor in a firm's investment and hedging strategy as improved risk analytics come of age,” he said in an interview.
According to the report, “2014 will be the year (money managers) start to take control of the capital commitment process. … New capital-oriented workflow tools will lay the groundwork for the ultimate goal of running a swaps portfolio that demonstrates both cross-product margining efficiency and versatility that will have to be managed through an enhanced risk-management process.”
“The report reflects conversations we've had with managers asking them what they're thinking of, what are they focused on with collateral,” Mr. Rhode said. “They're at the early stage of this challenge.”
There's also a business bonus for managers, said Mr. Rhode: Along with saving resources for collateral, being efficient “makes one manager better than the next guy” by being able to provide competitive pricing, he said.
The report is based on interviews with executives at U.S.-based money managers, hedge funds, insurance companies and banks with a combined $18.1 trillion in assets under management, of which $7.6 trillion, or 42%, is allocated to fixed income. The firms deal in interest rate swaps and/or credit default swaps.
From those interviews, four key trends emerged for efficient collateral use:
- straight-through processing of trade execution and central clearing;
- independent margin calculation and swaps portfolio pricing;
- tools to reconcile margin call discrepancies; and
- transaction cost analysis.
Mr. Rhode said the trends “are ways we've seen (managers) optimize their performance in view of the new collateral requirements. It lets them see how their existing assets are deployed, and provides ways to understand the cheapest forms of collateral that will be within the standards accepted by clearinghouses.”
Straight-through processing — in which the entire procress is conducted electronically — is helpful because of the “holistic, circular view” it provides for each trade, from pre-trade to execution and post-trade, Mr. Rhode said. “As each decision is made, (managers) can see it dynamically,” looking for potential inefficiencies and higher costs per trade. Meanwhile, mechanisms to check on the right margin call and risk position have “a significant impact on an investment manager's cost,” he added. “Managers need the methods and mechanisms to justify the pricing.”
Mr. Rhode said TABB's analysis revealed “an astounding degree of passivity from some asset managers in terms of reconciliations and margin call checks. But for those who do check, the mechanisms can be as simple as calling up the clearinghouse or futures commission merchant (an entity that solicits orders to buy or sell swaps) and raising a dispute, to having a technology system in place to constantly monitor and raise alerts in every instance of a discrepancy. Some systems are more advanced than others and this is a young industry.”
Among other efficiencies, according to the TABB report, managers will continue to negotiate lower swaps clearing fees as brokers introduce fees that cover such things as margin processing, varied collateral types and intraday margin calls for swaps not prefunded.
Also, competition among clearing intermediaries for manager flow business will intensify, ultimately concentrating among a few market leaders that can provide the best price and execution.
In addition, the report forecasts that more managers will hire collateral officers to oversee such efficiencies. “The collateral and capital commitment now associated with swaps are as subject to complex market risk changes and volatility impact in terms of value,” Mr. Rhode said. “The collateral officer would oversee the technology requirements and be the 'human touch' to the multidimensional collateral management and risk analytics challenge. … As far as I know, there are no current examples of the CO out there. But we predict there will be.”