Investment managers cannot avoid a collateral headache – Investit report
In an effort to reduce the counterparty risk associated with OTC derivative trades, regulators are enforcing central clearing and strict margin requirements that limit eligible collateral to the most liquid and lowest risk assets, according to a report by consultants at Investit.
Although clearing is currently limited to a small subset of the standardised OTC derivatives, stringent collateralisation will soon be required for all non-cleared derivative trades, research authors Sarah-Jane Dennis and Gina McCafferty.
As Dodd-Frank Title VII and EMIR implement, investment managers will have to factor in the additional collateral requirements when making investment decisions.
“The most cost-effective way of collateralising OTC derivative positions may result in portfolios holding securities solely for operational purposes and not for performance. This is a likely scenario when the securities that are eligible for collateral do not fall within the portfolio’s natural security set,” the report said.
Alternatives to holding the eligible securities include collateral transformation services (for example repos, stock lending and collateralised loans) and credit lines, all of which carry costs that will impact performance returns and may be considered too high to justify, particularly in stressed market conditions.
“This is quite a fundamental change and investment managers need to be given the necessary cost information to make these decisions.”
According to research conducted by Investit on the topic of collateral management, 41% of firms have or are implementing cost modelling structures to assess the cost of OTC derivatives to the portfolio, and another 42% of firms have plans to implement cost models in the next 12 months.
The research, published in April, asked members of Investit’s Intelligence research service to what degree the new collateral requirements would impact their organisation.
Specifically looking at the response to the impact on their firm’s risk appetite, surprisingly 19% see a limited impact, 27% see no impact, and another 27% of firms feel it is too early to tell. With the degree of change required by the pending regulations and its impact on risk decisions, Investit said it would expect the number of firms planning for a ‘significant impact’ (27%) to be higher.
To avoid the problem, investment managers with low volumes of OTC derivatives in their portfolios are opting to eliminate or reduce their hedge (imperfect hedge), or shift to new risk hedging techniques such as swap-based futures in order to avoid the regulatory driven costs and operational headaches, Investit found.
“This may in some cases lead to investment managers using less regulated securities in order to achieve the same objectives. However, this can only be a short-term fix as it is only a matter of time before more regulation blocks these ‘solutions’,” research from the firm noted.
Read a summary of the report here: Synopsis of the Collateral Management research