As Europe’s asset managers prepare for the new over-the-counter (OTC) derivatives regulations, due to be introduced from 1 January 2013, they’re realising that the new regime’s implications go far beyond compliance. By introducing the safety buffer of a central counterparty, the European Market Infrastructure Regulation (EMIR) is driving up costs and might force some boutique managers to look again at their investment propositions.
EMIR’s full consequences have become clear in the past few months, since clearing brokers and collateral managers have set their pricing tariffs. By setting a high minimum annual fee, they’ve created a significant barrier to entry for smaller managers in the OTC markets.
We believe that small and medium-sized asset managers – for example with less than approximately $20 billion-$30 billion under management – will struggle to invest in the OTC markets, because these fees would prove a prohibitively damaging drag on investment performance. So EMIR will have direct strategic implications, forcing them to re-examine how they invest and the return profiles that they market to clients.
While the US and Asia are introducing similar regulations, Europe’s asset management industry is highly fragmented, with a proliferation of boutique managers and sub-scale funds. This dispersion means a relatively high number of the continent’s managers will need to examine closely how they react to EMIR in the coming months.
By introducing a central counterparty clearing house (CCP) to OTC derivative trading, the world’s regulatory authorities are acting to bolster the resilience of financial markets – so reducing systemic risk. But the significant costs to market participants are only now becoming clear.
We identified some of the issues last May, when we published our Future of Capital Markets survey, conducted jointly with Frankfurt University. We canvassed 26 of Europe’s leading OTC market participants, including three of the four largest global asset managers, 11 buy-side banks as well as seven of the top 15 global investment banks and clearing brokers. The survey showed that asset managers expected significant costs, both in preparing for the directive initially and then posting collateral on an ongoing basis.
In all, 75% of the asset managers we spoke to expected these costs of investment to increase. They also anticipated making changes to their front-office products, processes, staff and, in particular, systems interfaces. What’s more, all of the asset managers we spoke to thought that providing the collateral required by CCPs would be a challenge.
Also pointing to difficulties in the months ahead, as the new regime settles down, asset managers and clearing brokers had widely diverging views about what they wanted from a CCP. This difference of opinion suggested that they would have difficulty agreeing where to clear.
But since returning from the summer break and entering into detailed pricing negotiations with clearing brokers and collateral managers, asset managers have realised the true magnitude of the threat to performance from EMIR. The fee models of many clearing brokers and collateral managers involve charging a fixed minimum fee per fund or account, which becomes only a relatively smaller number when the number of OTC derivatives transactions or notional amounts is very high. For smaller asset managers that make only occasional use of OTC derivatives in their portfolios, the cost could potentially strip several basis points annually from performance.
When deciding how to adapt to this new reality, asset managers have a few options. If institutional clients have several different dedicated funds or accounts, they might ask them to set up an overlay account for OTC trading, which would effectively reduce the costs through scale. Alternatively, they could look into using exchange-traded derivatives to achieve the same investment outcomes, but in reality these standardised derivative contracts don’t offer the same flexibility and market coverage.
What’s becoming clear is that EMIR is not purely a compliance matter. It’s a directive with significant operational, investment and, more importantly, strategic implications.
From the operational and investment perspectives, asset managers need to review the best ways of moving forward. Operationally, they need to examine the best way to simplify systems interfaces with clearing brokers, perhaps through a collective industry standardisation initiative. When it comes to investment, they need to look into setting up OTC overlay accounts or exchange-traded alternatives.
But in some cases, asset managers will have to look into whether their current trading strategies still offer investors the return profiles they want. An apparently technical regulatory directive could trigger a move into completely different investment strategies.