The buyside have faced many challenges over the last few years, but 2017 is shaping up to be a vintage year.  And just like several bottles of Châteauneuf-du-Pape, this year is likely to leave a very large hangover.

The buyside have faced many challenges over the last few years, but 2017 is shaping up to be a vintage year.  And just like several bottles of Châteauneuf-du-Pape, this year is likely to leave a very large hangover.

There are many external drivers converging to create a perfect storm of unprecedented change in the derivatives markets:

• UMR (Uncleared Margin Rules), with the buyside impacted from 1st March 2017 in “cliff
  edge” style with a big bang implementation and no phasing.  Despite intense lobbying to the regulators, a postponement looks unlikely
• Acceleration of migration from OTC to
  clearing (shifting the focus on the cleared
  model from compliance to optimisation as magnitude increases)
• Initial impact of the next wave of regulation including UCITS, UK FCA Treat Customers Fairly (TCF), MiFID II, etc.

Unlike the sell-side, where regulatory impacts are largely uniform and generalisations can be made this isn’t the case for the ‘buyside’, a term that covers participants as diverse as pension funds, asset managers, regional banks and building societies to name but a few.  Even focusing on asset managers, the impact differs enormously between those using only uncollateralised FX derivatives and more sophisticated participants with existing collateral management infrastructure.  The focus for the former might be on building infrastructure from scratch in a matter of weeks whereas for the latter it is very much around the legal documentation challenge.

Impacts on the buyside

There are however several common themes emerging around the impacts on the buyside of this market change:

• Significant increase in margin call volumes due to several factors (dual CSA approach, zero threshold, reduced MTA, split calls between cleared / uncleared)
• A material increase in cleared collateral requirements: by late 2017, large funds would have been clearing for 18 months, by which time cleared IM could be significant and thus justify active rather than passive management
• Combined with the above, an increase in uncleared margin requirements accentuated by tighter eligibility and switch to daily processing
• Market shift to intraday processing (e.g. UMR requirement to settle some margin calls same day)
• Complete re-work of the legal framework supporting buyside derivatives trading

Whilst these impacts are not necessarily new, 2017 represents a ‘step’ change with the potential for material impact on fund returns. As a result, the business case for strategic investment in infrastructure upgrade will become more compelling.

Focus for investment

Given the breadth of the impacts set to hit during 2017, where should buyside firms focus their efforts? Four areas are likely to require investment by buyside participants to meet the challenges ahead:

• Operating model (especially operations and other support functions)
• Treasury Management
• Legal Framework
• Front office decision making

Operating Model: a step change required for asset managers?

An asset manager with around 50 funds under management might today only exchange collateral on 5-10 calls daily.   If the dual CSA approach is adopted, this combined with reduced MTAs, no thresholds and introduction of margining for funds with FX only could result in the same asset manager having to exchange collateral on 25-50 calls daily, representing a fivefold increase.

Another consequence of UMR is the shift to same day processing of margin calls; whereas today calls received may be processed during the day well into the afternoon, the need to settle collateral same day imposes much earlier deadlines of 8-10am. Using the simple example above, the capacity to deal with both effects would have to increase from 1 to 25+ margin calls per hour, with effort concentrated during the crucial 8-10am window.

Whilst the impact will differ by participant, this change should be the catalyst for many to review the suitability of their current operating model as the consequences of doing nothing could be significant with material impact:

• consistently meeting margin calls late under the new rules represents regulatory risk
• overnight financing charges may be imposed by the parties involved
• an inability to support same day settlement may rule out some counterparty banks which could result in higher swap prices

Hence 1st March is likely to represent a tipping point where the potential benefits far outweigh the costs of infrastructure upgrade.

Treasury Management: can the buyside cherry pick the best parts of the sell-side model?

The sell-side has long invested in treasury management infrastructure and more recently in centralised ‘collateral units’ to create a real-time view of cash and collateral availability with a ladder projecting usage over several days, which allows optimal usage of inventory.  Much of the buyside however operates cash management based on stale data from yesterday’s close to project current and future cash flows. 

The switch to intra-day processing, with collateral settling same day, creates a big incentive for the buyside to adopt sell-side treasury techniques.  Under the new regime, collateral moves will be agreed throughout the day right up until the cut-off times (which could be well into the afternoon for some assets).  In the case of a margin call for instance, the amount and type of inbound collateral might not be known until late morning / early afternoon.   The current passive approach would leave any ‘late’ cash received on custodian deposit at poor rates whereas an active approach would invest overnight at short notice yielding much better rates.  

Various market drivers over the next year are likely to make the case for investment in active Treasury management much more compelling.

The legal quagmire: an inconvenient truth

UMR has shone a spotlight on the buyside approach to creating, maintaining and using the legal documentation supporting OTC derivatives trading.  The effort to get existing legal data fit for purpose has been huge and highlighted many risks and issue with the current creaking infrastructure which will only be magnified by UMR.

A good analogy might be discovering your house has rising damp – the signs have been there for years, but in the short term it has been easier to ignore these and paper over the cracks, and at some point the problems unexpectedly reach a tipping point forcing urgent remedial action.  

And for many firms UMR has been the straw that broke the camel’s back, exposing fundamental deficiencies that can no longer be ignored:

• OTC derivatives trading permitted without supporting legal docs resulting in material (unknown) counterparty risk (inconsistency between trading systems and legal docs)
• The collateral management platform not reflective of CSA actual terms, creating risk that ineligible collateral could be accepted and operational cost in exception management
• Insufficient control around archiving and storage of legal documents making quick retrieval difficult (which is precisely what would be required in a stressed market situation)

Market factors are coming together to create a compelling case for action to completely rebuild the legal ‘ecosystem’:

• Creation of a single ‘golden source’ representing the master record of all legal terms and used by trading systems, collateral systems and any reporting or reference platforms
• Updated processes to ensure terms are accurately captured and maintained

As collateral optimisation comes to the fore, 100% accuracy of legal terms will be essential to avoid costly errors.   Take for example a non standard CSA with restricted cash but broader non cash eligibility (in terms of currency).   Under UMR non cash posting may attract an additional 8% haircut where there is a currency mismatch; such rules require watertight terms capture and dissemination to the collateral systems. The current laissez-faire approach where collateral preferences are high level will no longer work in the new environment.

Front Office Decision Making: the paradox of choice

The old bilateral model was very straightforward with a clear division of labour: fund managers focused exclusively on fund investment strategy, the execution desk for derivatives operated a ‘fire and forget’ model where any derivative trade was executed on the price alone and collateral management was in many ways an afterthought. Collateral terms were straightforward, static and broad and the magnitude and frequency of calls meant that little thought was required for the collateralisation process (if indeed it was required at all).

If the start of clearing in 2016 was the ‘canary in the coalmine’ for what is to come, UMR on 1st March is likely to represent the final warning for change before it’s too late.  The confluence of these two changes in particular will start to make a material difference to fund returns during 2017.  This unprecedented market change is likely to bring about changes which have been predicted for years but which have not (yet) quite left the drawing board:

• An incentive for fund managers to consider the true lifetime cost of derivative trading across multiple venues (cleared v non cleared, etc.)
• A move for fund accounting systems to more accurately attribute this true cost of derivative trading to the appropriate sub-fund both for optimal collateral usage but also to ensure compliance with TCF
• A driver for product managers to review the continued viability of certain products under the new regulatory regimes (e.g. share class hedging)
• A transition towards more targeted and sophisticated use of scarce collateral
• The recognition of the importance of accurate enterprise wide data repositories to maintain, store and update crucial data (e.g. legal terms, cost of collateral, fees, etc.)

Consider a fund with a large OTC derivatives book, which is likely split between cleared and uncleared. After 8 months of clearing, IM may now be into hundreds of millions and increasing, swap pricing is incentivising elective clearing and UMR will add further collateral cost from 1st March. Add on the direction of travel of collateral eligibility (towards cash), now may be the time for asset managers to introduce more sophisticated collateral management combined with integrated front to back flows to join the dots between the front and back office.   And in particular, a toolkit to assist decision making of both the front office (around execution venue selection) and the back office (around optimal collateral management).

Summary: how should the buyside forge a path through the swamp?

This article has explored several themes around the challenges the buyside faces in 2017.  Many of the ideas are not new and have been talked about for years (indeed Sep 2017 represents a decade since the G20 Pittsburgh summit). In some ways however, 2017 marks the end of the ‘phoney war’ for the buyside with two pillars of derivatives regulation (clearing and UMR) now firmly in place and maturing rapidly (Trump notwithstanding).   These are starting to make a real impact and moreover this can be quantified against real rather than theoretical data, which makes any business case for related strategic investment far more compelling.  A logical first step is to capture accurate metrics to support a business case (see Table 1).

These are some examples of the way market change is increasing the hidden cost to the buyside of transacting derivatives. For many, 2017 is likely to represent the point at which these costs start to exceed the investment in infrastructure required to counter these changes. Hence now is the time to look holistically at what strategic change is required to support the derivatives market of 2017 not that of 2006. And unlike previous years, hard data is rapidly becoming available to support this call for action.

This article was first published in edition 9 of Rocket, our magazine. Download available Rocket editions here, and save your up to date address in your profile to to indicate your interest in receiving a printed copy of the magazine. Copies are also available to purchase and subscribe to via the shop.

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