Terence Nahar, senior investment manager at Aberdeen Asset Management, says his business is driven by much more than regulatory change, despite the sell-side’s constant reminders of the severity of the reforms.
With widespread regulatory changes being implemented throughout the derivatives market, is this having a major impact on your business and trading strategies?
I see this a lot in terms of the media. It is easy to focus on regulatory requirements, but our client base is exposed to much more than just changes in the regulatory environment. The market is changing just by the fact that it is a dynamic market. So opportunities and threats present themselves on a continuous basis. So a lot of what we do is driven by what the market throws at us and our clients. The client base is also changing, so it is a mixture of those factors that play the part, not just regulations.
If you go by what clearing members or the sell-side say, you get an incomplete picture of what is going on. You have a demand side as well as the supply side, and the demand side is not just subject to regulations. The regulatory changes are much more significant for the sell-side.
For CCPs and clearing members they want to big it up, and banks want to have the justification for why their charges are now higher. That is why it is ‘regulatory driven’ because it is easy for them to make that case.
But we look further than that. Regulation is an important part of the mix but there are a lot more considerations that come into play.
As head of derivatives working for pension funds for almost a decade, how has your role changed over that time?
Liquidity has reduced significantly primarily on the back of regulatory push-back in terms of derivatives used and requiring less leverage being applied in the system, initial margin, variation requirements etc. but I wouldn’t put it all down to regulations. As I said that would be a gross amplification of what has happened in the market.
Pension trustees have become much more sophisticated in terms of their understanding of derivatives. In 2006 for pension trustees this would have been a new area. Take the term ‘swap’ for example, they wouldn’t really know where to place it. Now days they fully understand what it is, how it can be used to de-risk a fund and they are much more open to other products being used in terms of structuring and designing de-risk solutions.
Which products are you heavily involved in trading?
Interest rates derivatives, inflation derivatives, inflation options or swaptions, cross-currency swaps, GILTs on repo, total return swaps, equity options, equity futures, a bit of CDS.
Are there any products you are trading now more than ever before?
Recouponing is a good example. We have undertaken significant recoupon exercises on behalf of clients where we had the discretion to do so. From time-to-time, there are opportunities in terms of yield pick-up. A lot of our clients need protection against interest rates falling, and from time-to-time there are opportunities to express these hedges in the form of swaps, in other cases it might be in the form of buying long-dated bonds.
Others we are active in right now - swaption trades and swaption hedges, a bit of equity futures and options but not dramatically and in big sizes.
This is specific to one client, but at the end of Q1 we implemented what is colloquially called ‘Glide Path’ or ‘full de-risking journey’.
It is a pension fund where you manage the whole portfolio across asset classes and the aim is essentially is to get the client from an unfunded position to a fully funded position in a risk-controlled manner in a pre-agreed timeframe with several levers to play with.
LDI is mainly focused around fixed income assets, whereas Glide Path is more about managing the whole portfolio, being delegated the authority to switch in and out of assets on a pre-agreed methodology and take on the responsibility for that, and getting the pension fund from an unfunded to a funded position in a pre-agreed timeframe.
Despite highlighting that you look beyond just regulations in your role, which sets of new rules are impacting your business and your clients the most?
If you look at our client base, an important regulation which is pending is Solvency II for insurance companies. This means that insurers have to change their investment strategy to be compliant with Solvency II, that is one of the largest we have seen, in terms of the change of strategy that has taken place on the back of that, and that is still on-going.
In terms of pension funds, EMIR is clearly important. MiFID II less so, even though it is on the horizon, it is not a primary focus at the moment. Basel III is very important, indirectly in terms of the best execution we can achieve on behalf of the clients because the intermediaries are mostly banks. Those are the three main streams of regulations.
When do you take a look at each regulation?
Our group has already put central clearing pipelines in place for US Dodd-Frank simply because it was required for the business, but on the EMIR front, our client base doesn’t have to clear currently. In most cases they opt not to clear even if they could.
We do follow the regulations in terms of the length of time that EMIR took to come to fruition and get through the European Council, then the Commission, then ESMA, we have followed it but we haven’t put too much of our resources behind it. The other bits of regulation are similar, Basel III isn’t something we follow closely as it is an indirect piece of regulation that impacts us. We are certainly aware of the capital and funding requirements that the banks face as a consequence of Basel III with the leverage rules.
We position our portfolios in accordance with that.
You are active in the OTC derivatives space, but with collateral and margin requirements leading to rising costs and complexity when trading those products, how will your strategy change going forward?
The hedges we tend to go for are quite bespoke and focused on the client. We are hedging out specific client liability cash flow profiles and using swap futures or bond futures, for example, doesn’t give you enough granularity to hit all the different maturity buckets that you want to target. A much more clean solution is a recoupon exercise whereby you raise cash, use the funds to by nominal bonds, index-linked bonds, credit or corporate bonds to target the different maturity buckets that you want to target and replace the swaps with bonds.
The other alternative is central clearing, two months ago they started offering inflation swaps to clients. Before then I don’t think any pension or insurance companies would go down the central clearing route, now it is becoming more viable I would say. But this is very client specific.
A client that would sit on a large eligible collateral pool, might be willing to consider clearing early, partly because of Basel III on the bilateral side. The liquidity in the bilateral space is reducing, as it is with all asset classes. As it is with any asset where a bank performs an intermediation function, the liquidity is shrinking. It is just a reflection of the higher capital that they need to hold against any trade.
Given that there is a wider product suite available with clearing houses and given the fact that bilateral trading isn’t necessarily the cheapest alternative anymore for certain clients, I would expect to see some clients begin clearing in the next six months or so. But again, it is very client specific.
How else have changes to the OTC market affected pension funds?
In terms of non-centrally cleared derivatives and non-listed derivatives, one of the main things we have seen is banks putting much more focus on pricing and capital requirements and new funding implications.
With recoupon exercises, in 2014 a lot of pension funds that had interest rate swap hedges in place saw a significant positive mark-to-market rise in their hedges because of the downward trend of rates. Rates rallied by about 100 basis points over the period. This meant that they had an asset on their books with a lot of mark-to-market embedded into it. What tends to happen in those scenarios is that people would recoupon those trades, which essentially means restrike the rate at which you entered the swap into to be the then prevailing at-the-market rate, and then release the positive mark-to-market within those swaps.
In addition to that, the discount rate used for derivatives has always been close to SONIA (Sterling Over Night Index Average), if the credit support annex allowed for safe assets as collateral – so cash and GILTs. However, partly due to regulatory changes, banks have started to price the discount curve different to SONIA and essentially reflect the optionality of being able to post GILTs rather than cash as collateral, at a different discount rate than SONIA flat.
This is an example of one of the trends we are seeing in the market right now.
Will the buy-side begin clearing before mandates come into force in Europe?
The more sophisticated clients and those who are sufficiently funded and have enough eligible collateral to facilitate a move to clearing would consider it, but most wouldn’t.
But things can changes very quickly, if liquidity drops significantly in the bilateral space and it picks up in the centrally cleared space then people can change their mind, that is how the market works.
But we don’t have any clients that will go down the centrally cleared route if they don’t have to.
Inflation swaps are important products for pension funds, and LCH.Clearnet have become the first to provide clearing services for the products. Do you think there will be an uptake from the buy-side, even if it is not mandatory?
At some point, when the exemption runs out, pension funds will have to start clearing their swaps. When they do chose to, they will want to have an ability to hedge real rates, so just hedging interest rate swaps at a different venue to inflation swaps doesn’t make any sense.
That is the minimum requirement for a pension fund. Most of the liabilities are inflation linked so you can’t afford to bifurcate your hedges on two platforms, that would introduce some significant collateral inefficiencies.
The has been talk in the industry of ‘disintermediation’ from the buy-side, where there could be a move to become direct members of the clearing houses, is this something you see happening?
For the mega-asset managers I can see disintermediation working, but for most you simply don’t have the resources to commit to the risk management committee, the default advisory committee and all those committees you would have to commit to. It doesn’t make sense, I think it is only for the top tier multi-trillion asset managers.
Have you signed up with as many clearing brokers as you intend to?
I think so. You have seen the people who didn’t have a lot of presence in the UK pull back. Basel III is impacting the clearing members as well so depending on how re-pricing works in terms of a new cost structure being put in place, that might still change but for the moment we are okay.
The way we look at EMIR is that we want to be able to clear early should we chose to do so, but that does afford us the flexibility to change the pipelines up to that point, and we really do value that flexibility.
Are you concerned by the amount pulling away from the business?
With our clearing brokers, we went through extensive due diligence exercises so we are fairly confident that the members we selected won’t be in that position. We had some of names who exited through our doors and concluded that it wasn’t worth the risk.
Any fund with a lot of directional trades will be scrutinised due to the new leverage regulations.
How are you facing up to collateral challenges?
What we tend to do for clients within front office is provide them with collateral monitoring reports, and give them early warnings as to whether their derivatives hedges might run into collateral constraints. We call it the collateral heat map. Essentially what we show what would happen to their pool of available collateral and how much would be taken up to provide us collateral for their hedges for different scenarios of interest rates and inflation.
So we have this matrix of potential collateral restraints and we provide them with those types of warnings.
For pension funds, given the facts they are unfunded on an economic basis, hedging can’t be looked at separate from the investment management overall.
Because they are essentially faced with two problems. They don’t want to be exposed to unrewarded risks, and most people think of interest rate and inflation risk as insufficiently rewarded risk. At the same time they need to generate enough yield on their asset to get from an underfunded position to a fully funded position. They have got two goals they are trying to achieve at the same time.
What that means for hedging out the interest rate and inflation risk for many pension funds is that too much spare collateral is not very desirable as it doesn’t generate enough of a yield to get the fund from an underfunded position to a fully funded position.
So what we tend to also facilitate is the transfer of collateral from what we call the LFI pool to the return seeking asset pool so that the yield on the overall asset portfolio gets increased to meet the second requirement that many of these funds face.
Do you see collateral management moving to become a front-office function in the long run?
I don’t see the collateral management function being fully outsourced to the front office. Treasury management and collateral management is part of that and is becoming much more of a front office function for sure, but will it be a wholly owned front office function, I don’t think so.