In addition, the regulatory environments, (for example Dodd-Frank in US and EMIR in Europe) set a very high standard for banks and asset management firms in relation to the minimum requirements to trade derivatives. Dodd-Frank stipulates a need to have a swap execution facility, and EMIR a need to centrally clear OTC trades. These requirements need infrastructure and investment in people, systems, automation and so on.
Last but not least, are post-trade controls: all the monitoring processes that need to be present in order to manage the process correctly. It is essential to understand your risks through proper risk analysis, scenario analysis, sensitivity analysis: all the instruments that are used by the portfolio manager to understand what happens in case of a tail risk event. There are a lot of risks that might be sitting in your portfolio that seem manageable in a normal situation, but in the event of a tail risk you need the correct instruments to actually simulate what can happen. Sadly, we all know that in financial markets, a tail risk event has not been a rare occurrence over the last few years.
Buyside use of derivatives – Here to stay
Derivatives are a vital tool for the asset management industry, as they allow us to improve and enhance our investment process. If derivatives were not allowed for example, the number of transactions that we do quickly and economically using derivatives today, would have to be done using cash systems. We would sustain much larger transaction and operational costs, which eventually would be transferred to the clients. They would therefore see a deterioration in the cost of trading and consequentially, overall performance.
From a risk management perspective, not allowing derivatives (or creating a regulatory environment where the use of derivatives is not incentivised) would lead to a sub-optimal risk-return profile. This would be a cost to the final investors because derivative instruments allow us to specifically tailor the risk we want to hedge, for the time we want to hedge the risk, in a quick and efficient way.
Buyside use of derivatives is going to stay. The electronification of financial markets is happening not only on the equities and fixed income markets but also on the derivatives side. In the future, there is going to be a lot more automation in the way you trade derivatives which will help facilitate the operational complexity that usually results from the use of derivatives.
In Europe, more than 50% of asset management companies use derivatives compared to approximately 30% in US. Traditional firms in the past were less keen on this instrument, but now they trade derivatives and have the proper infrastructure to enable this.
There is of course associated cost. When you improve your volume by 100% you need to understand that derivatives are not free. While users don’t pay fees to trade them, the cost is embedded into their present value. So a cost-benefit analysis is needed when a portfolio manager wants to set up a position in derivatives. As a trading desk, we act as an adviser to the portfolio managers, sitting together with them, to ensure proper understanding of the best way to implement the strategy. We need to keep an eye on how much of the cost, in addition to trading, is involved downstream, including how many people are involved in processing that trade. The cost of trading derivatives means the cost of the entire infrastructure, including the organisational structure that you need to have in place to be able to trade. Cost will improve as we move to standardisation of derivatives, even on the OTC market. Currently, derivative trading is a bilateral contractual agreement between two parties, completely customised, and written on paper. Each one is different from another.
In the future, standardisation and automation will change this, and mean there will be fewer people involved in managing the operational complexities resulting from trading these types of instruments.
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