The phrase ‘cobra effect’ originates from the British colonisation of India. Mounting government concern with the amount of poisonous cobras prompted a reward for every dead snake. All well in principle, but as breeding snakes for profit took off, the initiative was scrapped leaving India filled with even more cobras than before. Reptile control aside, financial markets today face their own cobra effect, as they battle with the unintended consequences stemming from a wave of post-crisis reforms.
The Bank of England recently admitted they would be ‘flabbergasted’ if post-crash regulations did not have some unintended consequences for the financial system. And although no one is throwing away the rulebook – identifying where the rules may end up hurting the people they’re designed to protect is critical. As a case in point, no rule maker intended for such a direct cost to investor returns, but as the market beds in new regulations, in some cases this has become the unfortunate reality.
For example, hedge funds can now be charged a staggering 70% additional margin because of certain compliance changes, which ultimately filters down to hit their investors. Specific rules on clearing houses have introduced the charging of what’s called a “liquidity add-on” for large positions – something that’s proving to be a massive drag on returns. In a world where investors continue to demand more bang for their buck, why has this become such a big problem for hedge fund managers and what can they change to drive better returns?
Firstly, we must look at how regulation has overhauled market structure over the last decade. Before 2008, hedge fund managers, on the whole, had little understanding of derivatives margin requirements. It was considered to be a back-office problem and only thought about post-trade. Today, the implementation of new mandatory cleared and uncleared margin requirements, such as EMIR and most recently Mifid II, has significantly increased the cost of trading derivatives across the board and hit the bottom line as a consequence. From Q1 to Q4 last year, the amount of uncleared margin posted was up almost 25% (Source: ISDA). And the impact of these additional costs is exacerbated by recent macro trends such as slowly rising interest rates. As rates rise, so too does the cost of margin. Given that fund managers are in the midst of a price war on investor fees, which continue to go lower and lower, and are facing the threat of more flow moving into index trackers, these spiralling costs are an urgent problem.
So as the pressure mounts, old approaches to trading can now lead to major capital inefficiencies and must be addressed. But the problem is that understanding margin costs, and therefore considering the most efficient option before a trade, requires investment at this cost-conscious time for fund managers. The difficulties lie in the specific nuances of complex margin models, as very similar trading alternatives can lead to double the cost of capital. Only by having insight into the web of new models that drive capital usage can you hope to manage margin carefully. But the savings can be considerable, and directly result in more free cash to take on more risk, and generate those much needed higher returns. For this to happen a shift in mindset is needed, as fund managers will need to re-think derivatives trading and consider margin a front office problem, calculating the total cost of a trade before execution. There is a pressing need to move away from simply paying whatever margin is called now that the amount has increased staggeringly.
Holding more capital to guard against the next financial meltdown is all very well in principle. But in practice, tying up extra cash has triggered enormous costs which are ultimately shouldered by the end investors that regulation intends to safeguard. And here lies the cobra effect – the unfortunate by-product. As investors continue to scrutinise every penny, more firms will be pressed to reduce these huge costs, which can only be achieved by re-thinking approaches to margin – it can no longer be the afterthought it once was.
Peter Rippon is CEO of OpenGamma