The cost of managing risk

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

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.