Post-Crisis Reform Radically Reshapes Financial Markets
In the last few years, the financial markets have undergone dramatic change. While some of this is down to natural evolution, much of the change can be directly attributed to new rules introduced in the wake of the 2007 crisis. Regulators, legislators and central bank governors have been determined to avert another bubble bursting or an unexpected event that could threaten markets.
Lawmakers have targeted key financial practices for reform, radically altering the expectations and behavior of industry participants. The combination of the Dodd-Frank Act, European Markets Infrastructure Regulation (EMIR), MiFID ll and Basel lll signify the biggest regulatory change in decades. These reforms have resulted in major change to how financial products are traded, settled, collateralized and reported, resulting in deep and ongoing structural changes to the markets.
Impact on buy-side Firms
There is no doubt that these new rules are directly impacting buy-side firms – be they asset managers, hedge funds, insurance companies or pension funds. But while the changes have certainly brought challenges, they have also brought opportunities. Firms that can proactively evaluate structural and operational dislocations in the marketplace and tailor business models to leverage the opportunities while addressing the challenges will be in the best position to stand apart from their competitors. Revised business models call for revisions to supporting processes and systems. Buy-side firms should look to re-architect their processes and technology infrastructure with a goal to strengthen risk control and oversight, enhance transparency and improve efficiency of front-to-back office control functions.
“The credit crisis, and the regulatory response it spawned have fundamentally reshaped financial markets. While the changes have brought about challenges, they have also ushered in opportunities.”
Sell-Side Exits Bring New Buy-Side Business Opportunities
While the market reforms have impacted all players, it is the sell-side (liquidity creators) institutions that have borne the regulatory brunt much more than buy-side (consumers) institutions, thanks to the central position they hold in the global financial system. The worldwide reach of the sell-side, their size and interconnectedness to other institutions make their survival critical to the survival of the entire system, hence regulations are designed to protect the financial markets from the systemic risk stemming from these institutions.
One set of regulations is focused outright on preventing banks from engaging in high-risk businesses. The Volcker Rule bans proprietary trading and prohibits a banking entity from owning interest in a hedge fund or private equity fund that might engage in proprietary trading. This has a potential negative impact on liquidity and the loss of a significant source of revenue. However, buy-side firms that understand the Volcker Rule, and can design new ‘Volcker compliant’ vehicles will be well positioned to minimize its impact.
Another set of regulations is focused on imposing higher regulatory capital charges on banks, especially for high-risk products. At a macro level, Basel III mandates that banks should progressively reach a minimum solvency ratio of 7 percent by 2019. At a more granular level, the capital required to hold certain high-risk products is prohibitively high.
One of the consequences of the regulatory focus on sell-side institutions is the breakdown in the clear demarcation of functions between the sell-side and buy-side institutions. Sell-side firms are withdrawing from businesses they traditionally dominated. Buy-side institutions like hedge funds, large asset managers and private equity firms are stepping into this vacuum left by banks exiting these businesses.
By their very nature, strategies in these businesses and the asset classes involved require a more sophisticated set of models and analytics than what is supported by legacy buy-side model libraries and risk management systems.
Quest for Higher Yield Driving Demand for Buy-Side Analytics
The quest for higher yield in a low interest environment is another reason for hedge funds and asset managers to seek out alternative investments that promise higher returns. For example, the buy-side is showing a renewed interest in structured credit products as the low risk tranches of these products are offering a higher risk weighted return in the current environment. Naturally, these investments involve a higher amount of risk, which needs to be actively monitored and managed.
This has also resulted in a demand on the buy-side for best-of-breed analytics and next-generation technology frameworks to support more complex products, capabilities they have traditionally lacked.
A Clear Mandate: OTC derivatives Must Be Cleared Through CCPs
Regulation has also hit the OTC derivatives market. Most market participants are now required to clear standard derivatives using centralized (clearing) counterparties (CCPs). Clearing derivative contracts over CCPs involves the posting of initial and variation margin.
Buy-side firms which previously have not invested in sophisticated collateral management, collateral optimization and margin calculation capabilities are now having to do so.
In addition, there is the proposed requirement, whose implementation deadline regulators have extended by 9 months, that counterparties of a non-cleared bilateral trade must also exchange initial and variation margins. While these regulations are targeted at reducing the systemic risk in the financial system, they have the side effect of increasing transaction costs for derivatives, since collateral required for satisfying additional margin requirements has to be funded.
To be consistently profitable, firms will need to carefully choose execution platforms based on an independent comparison of costs of funding margins over the life of trades. These regulation-imposed changes in market practices call for more sophisticated analytics as well as better operational capabilities. Sophisticated models ensure profitability by factoring in all the costs of executing trades including value adjustments for counterparty risk, costs of funding margins (initial and variation) as well as costs of capital. Better operational capabilities ensure consistent analysis across the organization (Front Office through Back Office) in a timely fashion.
Improved Front-to-Back Office Technology Transforms Margin Challenges into Opportunities
In a world where collateral requirements are reaching prohibitive levels, it is paramount for buy-side firms to be able to anticipate, source, deliver and reconcile funding requirements in real-time. Capital is too much of a precious resource to be wasted away on over-estimated margin calls. To avoid squandering capital, some of the leading buy-side firms are implementing new improved front-to-back technology to gain a significant edge over the competition. Risk analytics, collateral optimization and faster trading processes are giving these firms a distinct advantage. In addition, there is a middle majority of firms well aware of the looming threat of lagging behind that are actively implementing similar capabilities in their systems – but in a less organized and less systematic way.
The more the buy-side can accurately comprehend risk, the better it will be at maximizing capital – potentially taking the unused portion and funding more profitable trades. In the past, managing margin requirements was a reactive task, performed at the end of the trading cycle, and done within administrative and back office operations, usually manually. Today, the buy-side is turning to new technology to give them a complete, front-to-back view of their global collateral assets to allow them to assess multiple sourcing and funding options in real time.