The buy-side share of the derivatives business has grown to record levels over the last decade, as they use derivatives in significant volumes to hedge risks or tap hard-to-access investments. But will this work be curtailed due to the clutch of new market regulations on the horizon?
It is a tricky situation to be in. On the one hand, investors have been grappling with a low interest rate environment and derivatives are being used more than ever to tap into higher-yielding investment strategies and hedge risk. On the other hand, new regulations like the European market infrastructure regulation (EMIR), Solvency II, UCITS V and MiFID II are putting ever more stringent requirements on investors, making it more costly and more complicated to use derivatives. Many believe this could curtail buy-side use of derivatives in the future.
So what is the deal?
Over the last decade, buy-siders have continued to grow their use of derivatives and significantly overtaken banks as the largest users of derivatives. In its semi-annual survey in April, the Bank for International Settlements found that the share of over-the-counter (OTC) derivatives activity of non-dealer financial institutions, including pension funds, insurers, mutual funds and hedge funds, stood at new records last year. Buy-side interest rate swap share was 83% at end-2014— almost three times greater than the 34% figure in 2001— while foreign exchange derivatives share amounted to around 45%. A portion of this has been driven by the need to get exposure to assets where cash liquidity is thin, in a bid to boost returns in the current low interest rate environment.
“We use derivatives if it gives an advantage over cash,” says Andreas Gruber, chief investment officer at Allianz. “There are situations where the derivative market is more liquid or where you want to reduce the bid-ask spread. Derivatives are attractive when you want to change the portfolio sometimes. If you want to diversify globally, in emerging markets but don’t like the currency volatility.”
Curtailing legitimate activity
But the majority of activity these days is hedging of outstanding exposures or to reduce volatility on balance sheets. According to a report released last August by the International Swaps and Derivatives Association (ISDA), the push towards derivatives for hedging is being caused by macroeconomic trends and a greater experience of derivative strategies. Of course, different sectors have different needs. According to ISDA, pension funds, for example, have been dealing with greater pressure to hedge long-dated liabilities as life expectancy grows across the world, leading to a greater use of liability-driven investment (LDI) strategies and interest rate swaps to manage volatility in funding levels. Insurance companies have also been struggling to meet their long-dated insurance liabilities in the current low interest rate environment and are relying more on derivatives to manage funding uncertainty. But insurers have also been deploying derivatives to tackle the increasingly stringent capital management requirements under Solvency II, the new global insurance regulation due in force next year, which call for more precise tailoring of the asset and liability mix – something that cannot easily be achieved through cash assets. A survey by consultancy Milliman last year found that 89% of insurers currently hedge interest rate risk, 83% hedge equity risk and 75% hedge currency risk, while 30% of respondents offset credit risk, 17% inflation risk, and 3% longevity risk with derivatives.
For mutual funds, investing in foreign jurisdictions has become a necessary tactic to generate increased sources of return and brings with it currency hedging issues which has undoubtedly required an increased use of foreign exchange derivatives. Inflation has also been a significant risk for all buy-siders to grapple with as inflation levels have disconnected from interest rates and monetary policy in many parts of the world. With rates set to rise in the near future, many see increased volatility on the horizon and the need for the buy-side to use derivatives to cope with this should continue unabated.
With all these challenges then, it seems an unfortunate moment to be facing up to a mountain of regulations that could reduce your use of derivatives.
“The regulatory focus has been to drive users towards more standardised contracts than bespoke,” says Barry Hadingham, head of derivatives and counterparty risk at Aviva investors. “If they’re not careful, it will curtail a lot of legitimate activity. If things are being done for legitimate risk management purposes and you stop those from happening it means you are potentially taking more risk and could end up with more volatility.”
Hadingham believes that the operational complexity of dealing with all the new rules at once could lead to increased operational risk which in itself would add to counterparty risk. He says Aviva Investors hasn’t itself changed the way it uses derivatives so far but admits that as the rules start to bite “you will get changes.” The regulatory forces have made it necessary to get up to scratch. Sink or swim is the message.
Shifting implementation dates
Apart from the operational complexity, new rules like EMIR which require derivatives contracts to be centrally cleared, will increase the cost of derivatives use. Over time this will be significant.
“Our main clients have long-term liabilities,” says Hadingham. “The positions they hold are very directional so a few basis points to cover the cost of repo transactions over a 30 to 50 year strategy does become significant.”
As far as derivatives clearing goes, the stringent requirements by clearing groups about who they include as members, might also make things harder for many smaller buy-side groups.
“Clearing members are more choosy about who they do business with,” says Richard Metcalfe, director of regulatory affairs at the Investment Management Association. “The environment is very challenging. It is harder to see the network growing because of the cost loaded onto members.”
Adding to all this confusion is the lack of clear regulatory timetables. Many of the rules, like Solvency II and EMIR, have been developed with shifting implementation dates, a source of frustration for the buy-side, and one which has complicated the approach to derivatives use. As Hadingham says:
“It has taken too long and been made too complicated. We have done everything the G-20 wanted us to do. I think we’ve got to the point where these things need to reach an endgame.”
Still, it’s not all doom and gloom. For many, these complications are a short-term factor, teething troubles which, once settled, could actually be for the benefit of the market and indeed spur derivatives activity in the long-term.
“The new rules do have some impact on capital but they will potentially increase the use of derivatives because there will be an increase in the level of security when things settle down,” says Paul Charie, head of buy-side business development at Fidessa. “It can be harder work and more capital intensive to use derivatives but you have to give the regulators a box tick because it makes things like AIG much less likely to happen.”
As a vendor, Charie says that he has seen more buy-side clients putting into place infrastructure to deal with the burden of derivatives risk reporting and trading requirements and that, despite the current burden on users, the picture points to a long-term greater use of derivatives. It seems clear that the need for buy-side derivatives use is not going away. The task for regulators is to refine, but not curb, this.