27 Apr 2012, Duncan Wood, Risk magazine
Buy-side firms come in all shapes and sizes, with their own strategies and investors, and their own strengths and weaknesses. But ask three of the buy side’s leviathans what their current top priority is, and they speak with one voice.
“The top issue for the buy side right now is implementation of client clearing,” says Ted Macdonald, New York-based treasurer at DE Shaw Group, and a board member of the International Swaps and Derivatives Association.
Two of his fellow buy-side board members at BlackRock and Pimco echo that sentiment, and the new regime these firms are facing has helped bring about a change in Isda’s culture. Once a solely dealer-run association, Isda invited buy-side firms to join its board in 2009, and has since been trying to provide a forum within which the over-the-counter market’s various stakeholders can work towards their shared interests – and, on occasion, thrash out their differences.
“The industry has always had a divergence of opinions, within the buy side or the sell side and also between the two. Isda has focused on allowing all sides to try to reach consensus on major issues. The open dialogue – and broader membership – has fostered this environment,” says Bill De Leon, global head of portfolio risk management at Pimco in Newport Beach, California.
The scale of the change facing the buy side is hard to overstate. Along with a requirement that all standardised OTC trades be centrally cleared come new rules on trading and reporting that, together, dramatically alter the OTC market’s traditional, bilateral structure. They introduce a number of new participants to the market – including central counterparties (CCPs), repositories and specialised trading platforms – and also threaten to change the existing relationship between dealer and client by forcing market-makers to quote against each other publicly to win business (Risk May 2011, pages 60–62).
The vision is a market in which counterparty risk is absorbed by margin held at the CCPs, new trading rules make the market more transparent and competitive, and reporting makes it easier to regulate. Buy-side firms agree with those broad goals, but aren’t finding it easy to carry their existing practices into the re-designed market – particularly as some of the detailed rules called for by the Dodd-Frank Act in the US and the European Market Infrastructure Regulation are still being written. Many of the biggest firms have tested the clearing infrastructure, but relatively few have done so over an extended period, or with large volumes of business.
“The progress so far is probably slower than I would have guessed two years ago, but there are a lot of complex and detailed problems that have to be worked through, and we expect there to be a lot of take-up over the next year, particularly once the Dodd-Frank deadlines are finalised,” says DE Shaw’s Macdonald.
Tackling block trades
Foremost among the problems is the treatment of block trades within the new system – an issue that helped convince some asset managers they could not afford to sit back as the new rules evolved.
“When we saw the first version of the Dodd-Frank Act, we very quickly realised that the fundamental business model of an asset manager – where we invest via many funds and accounts, trade blocks and then allocate out – was missing from the proposed rules. Our fiduciary duties as asset managers drove the industry to step in and have its own voice and business model represented,” says Supurna Vedbrat, co-head of the market structure and electronic trading team at New York-based asset manager BlackRock.
Today, many big asset managers execute OTC derivatives exclusively in blocks, across groups of sub-funds that have a shared investment or hedging need. The asset manager executes the trade, getting as close to the required notional size as possible, and then allocates it across the relevant funds, which can number anywhere up to around 50 – a process that currently involves only the asset manager, the sub-funds and one or more dealers.
In future, blocks that are subject to the new rules will have to be cleared, bringing new players into the process. Asset managers will still choose which dealers to execute with, but their individual sub-funds will be free to select their own clearing members, as well as the ultimate clearing venue. This raises the question of whether allocations should occur after a trade has been accepted into a clearing house – requiring a single clearing member to temporarily underwrite the risk associated with the whole block before other clearing members step in – or whether the allocations could be arranged after execution but before a trade is accepted into clearing.
In a final rule published on April 9, the Commodity Futures Trading Commission (CFTC) decided block OTC trades should be entered into clearing immediately after execution, and allocated to the various sub-funds by the end of the same day – a ruling that, broadly, allows buy-side firms to continue with their current allocation practices.
But that isn’t the end of the story. Although the industry now knows what is required, it isn’t equipped to meet those expectations, says BlackRock’s Vedbrat. Specifically, while clearing houses are able to accept blocks for clearing, asset managers need clearing members that are willing to provide immediate, block-level intermediation, which would be followed by allocation of those blocks to each sub-fund’s clearing member – a process that needs refining.
“The CCPs are still working on their buy-side offering, and the basic readiness of that offering has been very, very recent. The ability to handle block-trade allocations, for instance, is neither efficient nor smooth enough for us to be able to use it right now on a full-scale basis. The industry is also required to achieve real-time acceptance for clearing, which effectively means that, at time of trade execution, the trade has to be sent for clearing immediately. And there is no solution in the industry right now for an asset manager with many funds and accounts across multiple clearing members to be able to accommodate that rule in a cost-effective manner,” she says.
As with block trades, many of the changes being introduced in the OTC market affect all of its participants – buy-side firms, trading venues, CCPs and dealers in their executing and clearing roles – so making the market work requires co-operation and co-ordination between the various stakeholders. Isda recognised the problem and, in 2009, broke with 24 years of tradition by asking three buy-side firms to join its board – Axa Investment Managers, DE Shaw and Pimco. A fourth, BlackRock, was added the following year.
That was not a simple step to take, says Bob Pickel, Isda’s New York-based chief executive. “For a long time, the view was that dealers play a different role in the market – I wouldn’t claim they’re neutral, but they are larger and more central to the business, so there was an argument they should be the ones making the decisions at board level that affect the industry. But, over time, people realised that was a difficult position to defend and, while including buy-side firms might lead to more challenging debates, it was better to include them and have those debates, rather than trying to just force something on the market,” he says.
The buy-side board members recognise the shift was not an easy one for the association – and welcome it. “Isda has continued to evolve as the market has changed. The addition of buy-side members to the board means it has become more balanced in how it addresses issues that affect the entire industry – given its historical background of being sell side only, this is a big step forward,” says Pimco’s De Leon.
“Isda was predominantly a dealer-oriented organisation – the board of directors was solely a dealer group. That changed just over two years ago when myself and two other buy-side representatives joined the board. So Isda has been actively working to bring the buy side into the dialogue – to be the voice of the industry, rather than the voice of one part of the industry,” says DE Shaw’s Macdonald.
That was not necessarily an altruistic move. If Isda had remained an organisation run by dealers, it could have found its influence and relevance limited in a world where a single trade may involve organisations playing at least eight different roles – executing broker and client, trading venue, trade affirmation, clearing broker, clearing house, repository, and regulator.
“There was a realisation that the market is moving towards more interconnected, sophisticated and complex business models where you need different market participants at the table to tackle issues that impact everybody,” says BlackRock’s Vedbrat. BlackRock is represented on the Isda board by Stuart Spodek, a managing director and member of the firm’s fixed-income executive committee, but Vedbrat represents the company on Isda’s industry clearing committee, a new body the association created last year that brings together dealers, asset managers, hedge funds and CCPs to help speed up the adoption of central clearing.
A cynic might say the association recognised it had a credibility problem in an environment where politicians, press and public – rightly or wrongly – see derivatives as a cause of the financial crisis, and had to involve the buy side or be ignored. Not Isda’s Pickel – he argues the association had been moving in this direction for some time (see box, From closed shop to open house).
But BlackRock’s Vedbrat says buy-side voices tend to be heard more readily in the current environment. “My sense is that politicians and regulators want to hear from all market participants directly in order to have a credible, consensus-driven solution. Part of the agenda for the regulation is customer protection – and the buy side is the customer. So, when we’re voicing our concerns about potential gaps in protections that have been defined for us, regulators listen to that,” she says.
Pickel concedes that Isda’s engagement with regulators takes a different tone when buy-side firms are involved. He gives the example of a series of meetings with the chairman of the CFTC, Gary Gensler. “About a year ago, chairman Gensler contacted me and other groups in other organisations and wanted to start a discussion about implementation issues for all the rules they were working on, particularly related to clearing, but also other things like transparency and trading. So we had a series of meetings and we brought in not just the dealer firms, but also several asset managers and other buy-side representatives. And, frankly, more of the discussion was led by the buy-side guys, who wanted to emphasise that some of these decisions were going to have significant effects on their business. It was very effective to be there with both the buy side and sell side when discussing the issues,” he says.
It is not always a happy marriage. While the various protagonists in the OTC market have a common interest in ensuring it works efficiently, fundamental decisions still need to be made about which actors will bear risk, how much risk they will take, and how they are compensated for doing so. Those discussions can be painful. The prime example is the so-called give-up agreement, a joint venture between Isda and the Futures Industry Association.
The agreement was an attempt to create legal clarity around the post-execution and pre-clearing responsibilities of an executing broker, a client and the client’s clearing member for transactions that are not executed on a trading platform. It laid out what the parties needed to do – and how long they had to do it – when confirming details of a trade. It also described remedies if a trade failed to clear, including a possible compensatory payment by one counterparty to the other.
Dealers believe clearing fails will most often be the result of a client discovering – post-execution – that it has run out of credit with its clearing member, so the agreement included an optional annex in which the clearing member could also be liable to pay compensation in the event of a fail. However, it was able to manage that risk by pre-agreeing limits for its client with a number of different executing brokers.
The document caused a storm after it was published in June last year, with buy-side groups arguing the annex was a sneaky way of enabling clearing members to steer business towards their affiliated trading desks, and for the big dealers to limit the ability of clients to spread their execution business around a broader swath of the market. The CFTC accepted those arguments, rushed out a rule prohibiting elements of the annex, and – at a meeting in March this year – voted to adopt that rule. But the discussions that led to the publication of the agreement were just as stormy, and the inclusion of the annex – giving the market two very different options – was essentially because the two sides of the debate had been unable to compromise.
“I’d say the buy and sell sides were gridlocked on this for close to 14 months. We started talking about it at the end of 2009 and, in the end only agreed as it accommodated terms for each market participant – although still not everyone was completely happy with the outcome,” says BlackRock’s Vedbrat.
“There was clearly a difference of view and, if things are truly at loggerheads and you can’t get consensus, all you can do is give the market an option and leave it up to the counterparties to agree,” says Isda’s Pickel. “A similar thing can sometimes happen with comment letters, where you end up reflecting two different views. That’s not particularly persuasive when you send it to a regulator, but it’s the most honest way to reflect the diverging views of the membership.”