Questioning investors’ capability to manage OTC risk
More than 80% of respondents to a recent study by BNY Mellon, Mitigating Collateral Damage, reported their use of OTC derivatives is stable or escalating both in value and volume. Although there is no separate data on Asia’s institutions, the region’s derivatives use has likely increased recently, says Patrick Tadie, head of Derivatives 360, BNY Mellon’s new derivatives servicing business.
Asia’s institutions trade derivatives directly, but much of their exposure is indirect, via hedge funds, synthetic exchange-traded funds and other products. IPA has been reporting that the region’s sovereign funds, pension funds and endowments have been increasing allocations to alternative assets such as absolute return products. They have also been transitioning portfolios more actively since the financial crisis, and transition managers often use derivatives to implement new strategies or stabilize performance.
Some institutions are increasingly using exchange-traded funds; a Greenwich Associates survey found that a third of Asian institutional investors employ ETFs. Notably, most of the ETFs in Asia are synthetic―of 69 ETFs on the Hong Kong Stock Exchange, 49 are synthetic― which means they use derivatives substantially.
A number of Asia’s institutions also invest in inflation-linked bonds, which have an underlying derivative exposure. Inflation-linked bonds are 3% of the Government of Singapore Investment Corporation’s more than US$300 billion portfolio and 1.3% of the Korea Investment Corporation’s US$30 billion portfolio, for example. GIC has had a 3% allocation to absolute return strategies for two years to March 2010. KIC’s alternatives portfolio, which includes hedge funds, strategic investments, commodity, private equity and real estate, is 6.8%.
In markets where pension funds use liability-driven strategies, the BNY Mellon study found that assets are divided into two pools: The LDI pool uses OTC derivatives substantially to hedge against changes in interest rates and inflation. The second pool is invested for capital appreciation. As pension funds’ largest allocation tends to be fixed income, pension funds also use credit default swaps extensively to hedge risks or to implement specific strategies.
Risk concentration is another danger. According to the International Swaps and Derivatives Association, the 14 largest broker-dealers’ OTC derivatives agreements are mostly with institutional investors, who account for 41% and hedge funds, 26%. This suggests that institutional investors, either as direct portfolio manager or via an external mandate, account for more than half of OTC derivatives.
The Bank of International Settlements considers OTC derivatives contracts’ gross market value, or replacement value, to be a proximate measure of counterparty risk. BIS’s latest triennial survey found that this measure escalated by 120% to US$125 trillion in the three years to June 2010. During derivatives’ halcyon days, gross market value only rose 74% from 2004 to 2007 to US$11 trillion.
But investors are also favouring less complex derivatives these days. The ISDA Market Survey shows that interest rate and cross-currency swaps had an outstanding value of US$434 trillion in the first half of 2010, far higher than the US$347 trillion in the first half of 2007 and US$382 trillion in the second half of 2007, before the credit crisis erupted. The Bank of International Settlements estimates that interest rate derivatives account for 82% of total OTC products’ notional amounts.
On the other hand, equity derivatives and credit default swaps’ notional values haven’t returned to pre-crisis levels. In fact, CDS’ outstanding value has declined steadily to US$26.3 trillion in the first half of 2010 from an all-time high of US$62.2 trillion in the second half of 2007, according to ISDA.
Indeed, since the global financial crisis, investors have preferred plainer derivatives. “There has been a push for simplicity and interest rate swaps are among the least complex derivatives,” Tadie says. Even so, few institutional investors have the capability to adequately assess their counterparty risks. Andrew Gordon, BNY Mellon’s head of broker dealer and alternative investment services, Asia Pacific, remarks, “Institutions have become adept at stress-testing portfolios after the financial crisis, but few can stress-test for counterparty exposures and concentrations. Many institutions don’t even independently price their derivatives, but instead get them from the counterparties.”
Asia’s major institutions have general counterparty risk management guidelines, but they seldom refer to counterparty risk concentrations. KIC, for example, says it manages counterparty credit risk by using indicators such as CDS spreads, CDS-implied ratings, bond-implied ratings, equity-implied ratings, and credit ratings provided by credit rating agencies. There is also the issue of managing collateral. “A change in tenor or interest rate can change the value of a derivative, needing adjustments in collateral. Sometimes, because institutions cannot price accurately, they end up with too little collateral, which is not a good idea, or they have too much collateral, which is not an efficient use of assets,” Tadie says.
The financial and labour cost of establishing the full counterparty credit risk framework, which large banks usually have, can be enormously expensive. It includes standardized documentation developed by ISDA; a credit limit framework that can inform decisions pre-trade; a comprehensive OTC derivatives exposure measurement and reporting framework; daily portfolio reconciliation with the key counterparties via multi-lateral reconciliation platforms; daily margin call adjustments to match collateral with changes in exposure; among other capabilities. The expense is unlikely commensurate with institutional investors’ minor allocations to derivatives. Hence, Tadie thinks more institutions will outsource the monitoring and reporting work.
But ultimately, having a top-rate framework isn’t going to dilute counterparty risk concentration because it’s a systemic issue. According to BNY Mellon’s survey, most institutions trade OTC derivatives with five to 20 counterparties. Most of the latter are the largest remaining broker-dealers after Lehman Brothers and Bear Stearns’ collapse.