The cost of man­ag­ing risk

Fund strate­gies are be­ing sti­fled by cap­i­tal and liq­uid­ity costs, while cut­ting into in­vestor re­turns, writes Ruan Jooste

Financial Mail - Investors Monthly - - Feature -

Hedge funds, pen­sion funds and in­vest­ment man­agers will be charged more to do busi­ness with their prime bro­kers be­cause of an ar­ray of new cap­i­tal and liq­uid­ity rules, which will cap the amount of funds they will be able to ded­i­cate to their in­vest­ment strate­gies.

Basel 3 re­quire­ments, which are due to be fully in­tro­duced by 2019 by the SA Re­serve Bank, have raised the costs of pro­vid­ing cash and eq­ui­ties on loan to hedge and other funds, to set­tle their deals and achieve ab­so­lute re­turns.

South African banks have al­ready im­ple­mented the cap­i­tal re­quire­ments. How­ever, the cap­i­tal charge for credit val­u­a­tion ad­just­ment (CVA) risk on banks’ ex­po­sure to lo­cal over-the-counter (OTC) trades have been on hold for the past two years. This in­cludes rand-de­nom­i­nated OTC de­riv­a­tive trades and non-rand OTC de­riv­a­tives traded be­tween do­mes­tic en­ti­ties.

In the­ory, as of Jan­uary 1 this year, South African banks be­came sub­ject to CVA rules. “That is where a bank is re­quired to hold ad­di­tional cap­i­tal when en­ter­ing into an OTC de­riv­a­tive trade with an out­side coun­ter­party,” says Hedge Fund Academy CEO Mar­i­lyn Ram­plin.

“As with costs as­so­ci­ated with cap­i­tal re­quire­ments, the lat­est charge will def­i­nitely be passed on to as­set man­agers through higher trans­ac­tion costs, which could af­fect the per­for­mance of their funds and sub­se­quently re­turns to their in­vestors.”

CVA rates are mostly ap­pli­ca­ble to non-centrally cleared, bi­lat­eral trades. That is where a de­riv­a­tive trade is con­cluded be­tween the bank and an­other party (the as­set manager) and the trans­ac­tion is not pro­cessed by an im­par­tial clear­ing third party such as lo­cal clear­ing house Saf­com or an ex­change like the JSE.

“The charge is de­signed to cover po­ten­tial losses that can arise when the coun­ter­party’s fi­nan­cial po­si­tion wors­ens, even though there might not nec­es­sar­ily be an ac­tual de­fault,” says Ram­plin.

She says the ad­di­tional cap­i­tal charge will in­crease the price tag of riskier ex­po­sures, while bi­lat­eral trades will re­quire coun­ter­par­ties to post both vari­a­tion and ini­tial mar­gin.

Ina Meir­ing, a direc­tor at Werks­mans Ad­vi­sory Ser­vices, says it is ex­pected, how­ever, that the CVA ex­emp­tion will be ex­tended in 2015, since a cen­tral coun­ter­party (CCP) for OTC de­riv­a­tives — in terms of SA’s G20 com­mit­ment to ad­dress OTC de­riv­a­tives re­form — has not yet been es­tab­lished.

Fur­ther­more, the Fi­nan­cial Ser­vices Board said in its eighth progress re­port on the mat­ter, in Novem­ber, that the mar­gin re­quire­ments will be im­ple­mented in De­cem­ber ac­cord­ing to the timetable agreed upon by the Basel Com­mit­tee on Bank­ing Su­per­vi­sion and the In­ter­na­tional Or­gan­i­sa­tion of Se­cu­ri­ties Com­mis­sions.

De­riv­a­tive re­form will be driven by the Fi­nan­cial Mar­kets Act, which be­came ef­fec­tive in June 2013. Draft reg­u­la­tions re­gard­ing OTC de­riv­a­tives were re­leased in 2014.

The act’s fo­cus is on en­hanc­ing the trans­parency of OTC de­riv­a­tives and re­duc­ing sys­temic risk by re­quir­ing trad­ing plat­forms, re­port­ing to trade repos­i­to­ries, the estab­lish­ment of cen­tral coun­ter­par­ties, and by set­ting min­i­mum cap­i­tal and margin­ing re­quire­ments, says Meir­ing.

Ac­cord­ing to the FSB re­port, it is ex­pected that re­port­ing re­quire­ments for all in­ter­est rate de­riv­a­tives in SA will be­come ef­fec­tive in the sec­ond half of 2015. Other as­set classes will be phased in over the fol­low­ing twelve months.

“Of course, this as­sumes that by that time a trade repos­i­tory (TR) will have been es­tab­lished and duly li­censed as re­quired by the FMA,” says Meir­ing. “All trades in in­ter­est rate de­riv­a­tives will then have to be re­ported to this TR and will be mon­i­tored.”

Meir­ing says the in­ten­tion is that the TR will main­tain a se­cure and re­li­able cen­tral elec­tronic data­base of trans­ac­tion data per­tain­ing to OTC de­riv­a­tives, which will be dis­closed to the reg­u­la­tors so that they are able to mon­i­tor po­ten­tial risks.

Also, mar­ket play­ers are as­sess­ing whether SA needs its own cen­tral clear­ing house for de­riv­a­tives trades, which is a very small mar­ket, or just pig­gy­back off es­tab­lished in­ter­na­tional coun­ters like the LCH.Clear­net Group in the UK. Many South African banks are al­ready us­ing those fa­cil­i­ties for cross-bor­der trades.

De­riv­a­tive re­form will be driven by the Fi­nan­cial Mar­kets Act

Mar­i­lyn Ram­plin … higher trans­ac­tion costs eat­ing into prof­its.

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