Regulatory reform will make derivatives markets more complex, introducing new participants and a host of new practices. That is forcing the dealer community to work with buy-side firms to a greater extent – but the two sides don’t always get along. By Duncan Wood
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.
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
“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.
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