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Innovation: The ‘missing link’ in a new world

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In the new world of interest rate derivatives, asset managers need to engage in product innovation and technological change, argue David Bullen and Gavin Dixon 

At a glance

• Regulation is driving significant change in the interest rate derivatives market.
• The range of exchange-traded derivatives will grow, but OTC products will continue to exist.
• A link between OTC and exchange-traded derivatives, such as interest rate swap futures, is needed.
• Asset managers focused on product innovation and technological change will thrive.

Interest rate markets have changed substantially since the financial crisis, both visibly and also less obviously in their market structure. These differences challenge asset management firms attempting to operate on behalf of their clients, especially in liability-driven investing (LDI), where the rules and market are continuing to change around them. The risk-management requirements of LDI challenge asset managers, who turn to banks for solutions and liquidity in their desire to transfer risk on behalf of their clients. 

Regulations such as Basel III, in particular the capital requirements within the leverage ratio rules, have significantly increased the amount of capital that banks are required to hold. This, coupled with the funding and liquidity requirements of the liquidity coverage ratio and net stable funding ratio rules, has severely restricted or, in some cases closed, some of the business lines of banks – for example, repo and swap-market making. Consequently, the cost of accessing these products for the end user is much higher.  

As a result of the leverage ratio, banks have withdrawn from, or re-priced, their balance-sheet-intensive businesses. For firm evidence of this, one need look no further than the existence of the London Clearing House (LCH) to Chicago Mercantile Exchange (CME) ‘basis’ in cleared interest rate (IR) swap pricing, whereby equivalent swaps are priced differently at the two institutions. This re-pricing phenomenon has prompted new entrants to join the market who are happy to step into new areas to provide market services and liquidity. Given some asset managers’ view that they expect and want to pay for leverage, it seems clear that market forces will encourage and reward these new entrants.  

It remains to be seen whether these attractions will be strong enough to encourage asset managers themselves to act as market makers to any meaningful or consistent extent. The advent of a broader range of exchange-traded derivative (ETD) products, with their more ‘all-to-all’ friendly trading protocol, will likely help bring about this outcome. The start of clearing of over-the-counter (OTC) products, with the ensuing removal of the credit-risk element post-novation to the clearing house, also directly facilitates asset managers’ access to new sources of liquidity. 

The repo market is a key area of change where there are already new entrants seeking to maintain liquidity, evidenced by the creation of collateral exchange efforts like DBV-X. The group’s CEO and founder, John Wilson, notes that Basel III has prompted dealers to withdraw capacity and widen spreads at a time when clients have growing collateral transformation needs.  

The advent of mandatory clearing has started to create an uneven playing field that favours trading interest-rate risk in exchange traded format, one-day value at risk (VAR) margining (for exchange products), versus five-day VAR (for OTC products). This means margining for effectively the same risk profile is far cheaper for exchange-traded derivatives (ETD) versus OTC and should, over time, drive more business towards ETD formats, both existing and new products, given best execution responsibilities under MiFID II.

OTC offers greater precision of asset-liability matching, whilst ETD offers better liquidity and transparency, suggesting both ETD and OTC interest rate risk formats will continue to co-exist. Current thinking suggests short-term IR markets and ‘imprecise’ hedging products will be ETD ‘owned’, whereas long-term IR markets, which provide a more precise hedging product, will remain OTC ‘owned.’ However, this does leave the increased cost squarely in the end user’s corner. The challenge for future liability-driven investment (LDI) users of IR markets will be to decide how and where to link effectively both ETD and OTC IR markets in practical terms.

A link between ETD and OTC derivatives is therefore needed. The evolving and new sub-asset class of IR swap futures is one tangible part of providing this link. Their form and attraction sit neatly between the precision and flexibility of OTC and the liquidity and transparency of ETD. The enthusiasm of providers to win in this race is apparent in the crowd that has gathered. 

Mandatory pension fund clearing will drive pension funds and, in turn, asset managers to consider using this new and evolving asset class. Their fiduciary responsibilities for best execution and optimum collateral create a drag on their clients’ and pensioners’ monies, likely forcing them to trade this new asset class. Generating a credible market in these new products will also drive them to lobby liquidity providers, high-frequency trading firms, brokers, investment banks and innovative exchanges to  provide products that address these needs. 

The traditional means of de-risking a pension portfolio from moves in the interest-rate environment has been through the use of OTC IR swaps. Investment consultants that advise pension schemes and other investors on de-risking trades are yet to hear about or understand the full economics of new IR asset classes like swap futures. Currently, they discount these products as too innovative, insufficiently liquid, or both. This situation is likely to change rapidly, largely due to the impact of capital requirements, on the one hand, and the push to clear derivative business on the other. 

Asset management firms’ technology tends to change at a glacial pace versus that of market infrastructure and banks, so those asset managers that can position themselves correctly will have an opportunity to disrupt and enter the LDI market with a cheaper, more transparent and flexible product offering based on both ETD and OTC interest-rate derivative products. 

Therefore, ETD and OTC will need to co-exist.  New instrument types, such as swap futures, whilst unproven, underdeveloped and new, are nonetheless an essential missing link in the IR markets of today.

Advanced new asset management operators offering LDI services, which provide flexible and transparent products and services that see the world as one linked continuum of IR risk, both ETD and OTC, are likely to thrive.  

There is a pressing need for active, old and new market participants of all types to step in and provide the traditional risk-transfer function of markets, with a steady eye on their business models. Also, a new generation of LDI products, including some form of alpha generation, needs to be urgently designed and adopted, given real yields’ flirtation with negative territory. 

“The best way to call the market structure correctly is to take a view and influence outcomes by being proactive,” says Ricky Maloney of the rates and LDI team at Old Mutual Global Investors. This is something relatively unknown in the asset management sector, because it has historically been the banks that have driven such market innovations and change.  

Given what lies ahead, what should an asset manager do? 

• Spend time on market structure;
• Explore and understand new products like swap futures;
• Talk directly to product providers and innovators;
• Start to plan and budget for market infrastructure change;
• Seek information from bank and non-bank sources; and 
• Compare the pictures and data provided.   

Crucially, asset managers need to hold views on market structure topics and express them vocally, as well as sponsoring and founding new markets. Welcome to the world of picking winners, perhaps the other missing ingredient on the journey to the new interest rate risk-transfer markets.

David Bullen is an independent adviser specialising in European fixed income market structure change and former head of global rates and credit e-commerce at Citigroup Global Markets. Gavin Dixon independently advises several financial services institutions, and is former EMEA head of derivatives clearing at BNP Paribas

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