The impact of new regulation on banks has been the subject of fevered debate in the recent years. What share of the pain has the buyside had to endure? Michael Watt reports.
Stymied by their lack of clout in the policy-making process in recent years, investment banks have often fallen back on dire warnings of higher costs for buyside clients, and consequently the real economy, if politicians and regulators put too hard a squeeze on the industry.
This tactic – ‘never mind what happens to us, look at what will happen to our clients’ – has not been enough to ward off an extremely tough time for investment banks. Capital and liquidity standards have been raised significantly. The structure of the over-the-counter (OTC) derivatives market is being shifted onto an ostensibly safer, more transparent footing through central clearing and registered trading platforms. The upshot of all this is higher costs for banks, with many dropping out of part or all of the market. European banks have caught the brunt of it. Deutsche Bank’s well-publicised troubles in the early months of 2016 stem, in part, from its investment bank no longer functioning as a great revenue engine.
Silent protest
The effect on the buyside, however, is less well studied. Though banks have made a great song and dance on their behalf, many firms admit that their own voices have been somewhat lost in the din. “Despite being well represented through trade bodies, historically the buyside hasn’t been as skilful in terms of lobbying politicians and regulators as the banks,” says one trader at a large European asset manager. “It’s frustrating we haven’t found the right medium to make our voices heard.”
In theory, a reduction in bank market-making should make life harder for a whole range of firms. However, given the unprecedented nature of the change happening in investment banking markets, it is perhaps no surprise that it has also opened up windows of opportunity for many bank clients.
There is, of course, a huge range of entities that can be included in any definition of ‘the buyside’ - hedge-funds, pension and insurance funds, corporates, or general asset management institutions such as BlackRock or Pimco. However, most use the OTC market to some degree, and so face a similar set of changes.
Central clearing
One key reform is the introduction of central clearing for all standardised OTC derivatives, and, in parallel, the margining of all non-cleared derivatives. This will place new financial demands on a vast number of buyside entities, as more collateral will need to be put aside to cover out-of-the-money positions. The technicalities of posting collateral are generally covered by a credit support annex (CSA), the terms of which are now, in many cases, under review.
“Our OTC counterparties are already looking to review CSA terms to focus on cash, rather than traditional collateral assets such as bonds. Even highly liquid instruments such as gilts or other sovereign bonds have fallen out of favour because of new regulatory capital charges that make it very expensive for banks to hold these types of assets,” says Steven Swann, global head of trading at Standard Life Investments in Edinburgh.
“Certain market participants, particularly pension or insurance providers, probably hold lots of long-dated bonds, but very little cash. Those types of investment advisers may either have to change their portfolios, or deal with higher trading costs or increased haircuts on the bonds posted as collateral.”
Supportive environment
The introduction of central clearing, a major plank of the post-crisis reforms, has generally been supported by banks and buyside actors alike. Last year, BlackRock led a group of high-profile asset managers in a bid to back the mandatory clearing of credit default swaps, which it is hoped will help revive that particular instrument.
The actual pricing impact of clearing is not expected to be huge. Under the Basel III reforms, routing trades through central counterparties (CCPs) allows banks to make a risk-weighted asset saving of up to 80% compared with an uncleared trade. Less capital set aside for a trade means less cost passed on to clients. Though derivatives users will be hit with commission costs from newly mandated trading platforms such as swap execution facilities (SEFs) in the US and organised or multilateral trading facilities in the EU, the new market structure should open up access to far more counterparties than before. This extra choice should lower execution costs, which can be a serious drag on asset manager performance.
“We should be wary of comparing what an OTC trade costs now with what an equivalent trade would have cost five or 10 years ago. That isn’t comparing apples with apples. The introduction of clearing, platform trading and other structural changes means that the modern-day OTC trade is a completely different beast,” says a regulatory expert at a major US asset manager. “If costs are higher, then we on the buyside have to accept that this is an inevitable consequence of a safer, more multilateral and more transparent market.”
How high?
The effect of higher prices may not be equally distributed among all types of buyside participants, with smaller institutions perhaps feeling most of the pinch. “We haven’t seen a large impact on pricing from banks, but I suspect that as a large asset manager we are perhaps insulated from some of that at this point. I know that banks are focusing more on their risk-weighted assets as a consequence of banking regulation, and this has led them to be more selective about how they deploy their available capital ” says Mr Swann at Standard Life.
The Alternative Investment Management Association (AIMA) recently made an attempt to quantify the exact extent to which prices had risen for buyside participants with a survey of its members. Eighty institutions responded, representing a combined assets under management value of more than $400bn. Though these members are almost exclusively from the hedge fund community, the survey looked at prime brokerage and derivatives-dealing relationships with banks, which are generic to many buyside firms.
“Our survey clearly showed that buyside costs have increased. Half of the respondents said that trading and other aspects of the banking relationship have gotten more expensive. Of that half, we had a roughly equal split between those who had experienced cost increases of up to 10%, and those who had experienced an increase of more than 10%,” says Adam Jacobs, global head of markets regulation at AIMA in London. “That is a potentially material increase that could lead to a big increase in operating costs.”
Wider efforts
It is not just derivatives trading that is feeling the effects. “We also asked questions about cost changes in different types of financing – derivatives, securities lending, etc. What stood out was repos – 60% of respondents said costs had increased in this market,” says Mr Jacobs.
Aside from the cost question, AIMA looked at whether its members were increasing or decreasing the number of prime brokerage or dealer-bank relationships. Some 90% said their number of relationships was stable or had increased. Smaller managers said that the rationale behind this was counterparty risk management, whereas for larger managers it was more about improving access to liquidity.
“It’s important to remember that the impact of Basel III and other regulatory changes isn’t uniform across all banks that an asset manager might deal with,” says Mr Jacobs. “You have to consider the constraints of each counterparty based on jurisdiction, client mix and business lines.”
This evidence is at odds with the experience of many asset managers with large OTC portfolios, who have seen the number of available bank counterparties slip to a smaller and smaller number.
“Our pool of banks has definitely shrunk. The available counterparty list is consolidating. That may become a challenge for us, because we rely on a panel of banks to ensure we deliver best execution for our clients, which is a central tenet for asset managers. If that pool of banks shrinks to the point where it becomes difficult to source liquidity, we may see that translate into wider spreads,” says Mr Swann.
A real problem
This lack of liquidity is not just a theoretical problem. The reduced ability of banks to take and hold risk, which usually acts as a safety valve for the market, has been blamed for the high volatility experienced in equities and bonds across the world in recent months. Worse, buyside participants now act in a far more geographically fragmented environment. The different pace of regulatory change in Europe and the US has created incompatible standards in clearing and trading platform use, meaning that buyers and sellers in OTC markets are increasingly restricted to domestic markets. This further reduces liquidity, and increases the potential for low-key events to create high volatility.
“Perhaps regulators want to limit the use of derivatives based on the assumption that it will produce a safer market. We obviously support protecting our clients’ interests through better regulation, but indirectly restricting our use of derivatives may make it harder to efficiently manage funds and deliver returns to investors,” says Mr Swann.
“If you take away or reduce the capacity to use OTC instruments to efficiently hedge your asset base, then you’re asking us to operate with one hand tied behind our backs. We’ll be forced to look for less efficient hedging strategies, which may have an impact on returns we can generate.”
Clear danger
A general retrenchment by banks from the market also poses dangers to the clearing process. Because most buyside firms do not have the financial clout to join CCPs directly, they clear their trades through clearing member banks. When mandatory clearing was put into motion, many large dealer banks envisaged a strong revenue stream emanating from this clearing member-client relationship.
This revenue has failed to materialise, in part due to unexpected costs and the slow pace with which mandatory clearing has been introduced. A few years ago, many banks were keen to clear entire client portfolios, but this enthusiasm has dimmed. Now, buyside firms are being told that they will need a whole host of clearing-member banks, each taking a small slice of their portfolio. Some banks, including Nomura, Royal Bank of Scotland and Bank of New York Mellon, have pulled out of client clearing altogether.
Regulators have long focused on the risk of clearing member default. In that scenario, other banks must take on trades cleared by the bank that has gone bust, and the CCP must ensure that any losses suffered by that bank’s counterparties as a result of the default are made good. However, perhaps a more likely, though less apocalyptic, scenario is one or more of the largest banks suddenly exiting the client clearing space because they can no longer make a profit in it. Finding a new home for all those trades among an even smaller number of clearing members may be exceptionally challenging.
Gap in the market
One remedy for the loss of OTC liquidity from banks would be for the buyside to step in and act as sellside market-makers themselves, facing other buyside participants. Recent structural changes to OTC trading allow them to do this – new classes of platforms such as SEFs allow any user to make and take prices in a multilateral trading environment.
Chicago-based hedge fund Citadel Securities has already established a fixed-income derivatives trading business in both the US and Europe, grabbing market share from traditional sellside banks. However, this is not going to be suitable for everyone, even other hedge funds.
“In our survey, members were asked about the need for disintermediation and direct trading relationships between asset managers, but members appear more focused on making prime brokerage relationships work properly,” says Mr Jacobs at AIMA.
Though high-frequency traders may play some role in meeting the liquidity shortfall, most institutional asset managers will, at best, take a cautious approach to providing prices.
“Some buyside firms are gearing up to be price-makers, rather than liquidity providers. The distinction between the two is if you are a price maker you have a real trade behind that, a real transaction that you need to execute. A liquidity provider, on the other hand, will provide intermediation based on what the market wants. A liquidity provider takes principal risk, a price-maker doesn’t,” says the regulatory expert at a large US asset manager.
“This is still a big change. We expect our traders to know where the market price is at all times, but working off those prices in a proactive manner requires a behaviour change. It is also a major lift from an infrastructure standpoint.”
