“Regulation as such would not be a problem, if only one knew how it looks like“. This is a claim often heard by asset managers.
There has been published a lot of literature, news and considerations around EMIR in the past months. EMIR applies its obligations to “financial institutions”, including investment firms, Undertakings for Collective Investments in Transferable Securities (“UCITS”) funds and their managers, and entities that will be authorized under the Alternative Investment Funds Managers Directive (“AIFMD”), who trade in “eligible derivatives contracts” such as options, futures, swaps, and contracts for differences.
Interestingly, even if the obligations apply to not just banks but financial institutions in general, it is important to mention that procedures for the implementation for the different types are not catered. For asset management it leaves a lot of space for interpretation; in particular the constellation of having an asset management company, fund manager and custodian implies a great challenge to find the right interpretation and implementation respectively in order to achieve compliance with EMIR. Therefore, this commentary will serve to draw on the biggest challenges an asset management firm is faced with.
Challenge 1: Each fund is an own legal entity
The biggest difference for asset management companies in contrast to traditional banks is the fact that each fund counts as an own legal entity. This implies a lot of challenges and pitfalls.
When selecting a clearing broker, it needs to be kept in mind that the entire onboarding procedure needs to be carried out for each fund holding OTC derivatives. Just the identification of affected funds might take a lot of time, since not only funds that are currently trading OTC derivatives are of interest but also those which potentially could trade OTC derivatives based on the terms and conditions of the fund.
When looking at the fee structure further challenges appear: some funds trade a lot, some less, some not at all. Here questions such as “How to set a minimum fee – per fund or per asset management firm?” arise. Such questions also arise regarding the limits towards the clearing broker. Those details need to be negotiated and imply that clearing brokers will need much more time since they need to go through each fund individually.
Regarding client reporting offered by clearing brokers, asset management firms need to think about the netting options for margin calls offered by clearing brokers. The call will be set per fund, but no company wants to receive hundreds of calls a day implying to make hundreds of payments.
The launch of a new fund marks a further challenge because it needs to be considered that a fund needs to be authorized by the competent authority before the onboarding procedure can start. However, the fund needs to be fully invested the day it is authorized. This implies that a solution together with the clearing broker needs to be found to onboard the fund before it becomes a legal entity.
Challenge 2: Timely obstacles towards reporting obligation
The second challenge refers to the obligation to report all derivatives to a selected trade repository. The establishment of an interface to the trade repository will be a challenge as such; the most difficult part however will be the collection of requested data on time from all parties managing the funds.
Even if the reporting obligation is said to be on a counterparty level, a practical interpretation would be that the asset management company will have the responsibility to report all assets they have under management; this implies also reporting trades executed by external fund managers. Since information of trade details is distributed throughout several fund managers and due to the many steps involved in the trade life cycle until details are available to the managing asset management firm, the challenge will be collecting relevant data from external fund managers on time to report T+1 at the latest. Furthermore, in case a legal identifier is required, it needs to be kept in mind that a LEI/CICI has to be ordered per fund which implies a lot of costs which must be considered when estimating incurring costs.
Challenge 3: Impact of new collateral requirements
Regarding the provision of collateral, the systematic introduction of the initial margin in addition to the already well-known variation margin marks a further challenge. Again, collateral must be provided individually for each fund. One fund cannot stand up for the obligation of another fund. The provision of such an initial margin, which is a permanent additional collateral buffer in the form of cash or securities whose value is regularly reassessed, will undoubtedly make life more difficult for asset managers and the optimization and transformation of a fund’s assets liable to be used as collateral will therefore become crucial.
Indeed, if a clearing house calls for collateral, the fund manager has to decide which collateral is the cheapest to deliver. Faced with a possible temporary lack of eligible collateral, cash or securities, the fund manager must also anticipate the transformation strategies which need to be implemented and which will most probably entail the setting up of lending/borrowing operations. Further decisions need to be taken when negotiating with the clearing broker if securities are provided in form of pledging or via title transfer. For asset management firms only pledging is a possibility which implies a fully segregated account structure because the fund will need back exactly the security that it has provided.
Another interesting discussion arises when thinking about pension funds. Since they are obliged to fully invest in order to secure returns for pensioners, they will have troubles regarding the provision of collateral in form of cash for the variation margin. Hence, more flexibility towards the types of eligible collateral is needed.
For custodians the challenge is to build suitable high-performance infrastructures capable of supporting a much higher and more complex daily volume. This requires substantial IT investment and robust processes have to be initiated at every stage of the chain.
In this context, the selection of the right collateral management solution is essential. For asset management firms an outsourced solution may be interesting since settlement is already taking place at the custodian. The benefits of an outsourced solution are tempting since there is less up-front spending, quick time-to-market, market expertise created by experts servicing multiple institutions can be utilized and, most importantly, arising fees can be offset against the respective fund so it does not need to be carried by the asset manager.
Awareness is given but uncertainty remains
Emanating from above, there are a lot of challenges asset managers need to cope with. Uncertainty is perhaps the most challenging one, since many decisions depend on regulatory developments and outstanding decisions. Custodians could be the new linchpin in this regulatory environment, since they could act as a technical intermediary between each asset management firm and CCP and take over several obligations. Indeed, the delegation of the reporting obligation could be quite tempting since the custodian is the panel point where information is accumulated. The latest developments show, that for ETD the custodian might be even obliged to report details to a selected trade repository.
One could argue that for an asset management firm it could be great thing to outsource the obligation of reporting or collateral management to their custodian. This would make life easier. On the other hand, it should be evaluated how much a firm want to be exposed to one party only. It also must not be forgotten, that the legal responsibility will always lie with the fund, hence with the asset management firm.
Another uncertainty remains regarding the question if FX trades are going to fall under the clearing obligation since many funds use such trades to hedge against currency risk. For instance, LCH.Clearnet sets strict requirements for market participants with which only a few comply with.
With the enactment of EMIR, asset managers may need to overthink which derivatives they want to use in the future. Some funds may have difficulties to provide sufficient cash, since fund managers normally try to keep cash low in order to invest capital to bring higher yields.
In spite of everything, many argue that EMIR also brings positive effects for asset managers: though enhanced transparency funds will be priced much better since derivatives can be traded on official trading platforms and though a standardization of derivatives, settlement is going to be easier as well.
Due to the high degree of uncertainty indications go towards a postponement of current timelines. This would mean that asset managers could breathe a sigh of relief. But it also means that a lot of work still needs to be done.
Source : FOXEYE