Picking up the bill
It is anticipated the administration costs for centralcounter parties will get passed on to the end investor. According to Axa IM’s Barron there are likely to be costs involved with converting gilts to cash – the repo costs – in terms of posting initial margin, the nature and maturity of the derivatives and the cost of finding additional collateral. Non-centrally cleared derivatives are also generally expected to become more expensive because other regulation affecting banks, such as Basel III, will increase the cost of derivatives not only in the centrally cleared world but also in bilateral trades. “So while pension funds have an exemption that is not to say they won’t find it potentially economically beneficial to move to central clearing at some stage in between that period. I don’t think we will see wholesale not using derivatives – it still makes sense for schemes to manage their risks and derivatives are a key tool for achieving this. Not using derivatives would be like cutting your nose off to spite your face,” says Barron. European Fund and Asset Management Association (EFAMA) director general Peter de Proft says there will be a cost impact to ensure alignment with new reporting standards and risk mitigation techniques.
“This will impact revenue of investors as costs will be at least partly transferred to investors and cost of transaction will increase,” he says. The resulting administration costs and those associated in order to provide the degree of oversight of the positions means a number of asset managers will have to contemplate significant IT spend. However, Royal London Asset Management (RLAM) chief investment officer Robert Talbut believes it will be difficult for fund managers to pass these costs onto clients, and like Barron believes the underlying clients’ costs will increase regardless. “For instance there is one estimate that the amount of extra collateral required by the system is a figure of $2.4trn,” he says. “If, for clients, that incurs an extra 1% in costs that is $24bn. These are not trivial sums of money so depending how large a user of derivatives you are will determine how much more expensive your hedging programme will be.” According to Russell’s Cook, the bottom line is that funds will still practice liability hedging because the risk reduction benefit will still be in excess of any extra costs EMIR will bring in. “We are talking basis points, not huge percentages,” he says. “You just need to take that into account when setting up your total portfolio.”
Elsewhere, there is a fear among the industry that while EMIR is meant to reduce risk in the OTC derivatives market, it might actually add concentration risk because with only a few CCPs operating in the market the amounts of collateral they are going to be managing is likely to balloon exponentially. Subsequently, in a competitive market CCPs will naturally seek to maximise the flow through their own firm which could result in a ‘race to the bottom’ through competitive pricing and risk monitoring. “The fear is because there is only a handful they know they can dictate and they know they are in a strong bargaining position,” says Culley. “We would not want competition between the houses to be solely based on price because the danger is there becomes a race to the bottom and then potentially you are concerned about whether these organisations are going to be adequately resourced themselves to provide the good quality service everyone wants,” says Talbut. But EFAMA’s de Proft believes the European Securities and Markets Authority (ESMA) is going to be prescriptive with CCPs. “It is important to avoid a systemic risk in the CCPs,” he says. “The main risk is if you get a concentration in a couple of CCPs.” Furthermore, the regulator must ensure with the increased focus on CCPs sitting in the middle of multi-billion pound trades that these entities cannot be allowed to fail. If a clearing house’s collateral requirements are lower people might choose to go through them but they are at greater risk of significant moves and even defaulting.
Taking the lead
But who should be taking the initiative in ensuring all the checks are in place for EMIR? According to Talbut, asset managers should get the ball rolling. Indeed, in November, RLAM announced it had successfully cleared £550m of vanilla interest rate swaps at the London Clearing House (LCH.Clearnet). Talbut explains: “We did not think there was an advantage for us in waiting and the feedback we get from brokers is it is a good position to be in. It could be a bit of an unseemly scramble to get this in place if the hundreds of thousands of other counterparties are scrambling to get things done. The initiative does need to come from the asset managers to enter into the different arrangements and get all the legals and regulations in place.” Bovill’s Culley agrees but suggests in the meantime pension funds start looking at the documentation they have in place. “I’m not sure how involved pension funds will be in the renegotiation of collateral documentation, such as CSAs and dispute resolution procedures, as they will probably expect their managers to do this on their behalf,” he says. “It is a case of checking managers are taking the initiative as this process may take several months.”
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