When an asset manager and a banker meet for a festive drink, who puts their card behind the bar? Traditionally, bankers have shown appreciation for business directed their way over the previous 12 months. More recently, greater regulatory scrutiny of costs and fees has required every penny be accounted for. This leaves the banker with less to be grateful for, and fewer ways of earning it. For the asset manager, it requires a rethink of operating infrastructures and even business models.
Having relied on the sell-side for multiple services, covering transaction processing and reporting, asset managers must now handle much tougher regulatory obligations with much lower levels of support from banks.
For decades, asset managers have bought and sold assets using tools, technology and information supplied by their brokers, leaving themselves operationally light and nimble, but open to charges of over-dependence on suppliers and potential conflicts of interest. This has been tempered more recently by greater regulatory scrutiny of supplier relationships and operational oversight, and scandals such as the recent collapse of Neil Woodford’s empire will ensure there is no let-up.
Banking reforms might have grabbed more headlines overall, but the buy-side is being hit just as hard. Having relied on the sell-side for multiple services, covering transaction processing and reporting, asset managers must now handle much tougher regulatory obligations with much lower levels of support from banks. This means, for example, many are starting from scratch when adjusting to the operational challenges implicit in new rules for trading uncleared derivatives.
Uncleared margin rules (UMR) have been rolled out gradually1, starting with the biggest global banks and brokers in September 2016, with only the largest buy-side firms captured in September 2019’s fourth wave. In July, sensitivity to buy-side challenges led regulators to delay compliance for the smallest among the fifth wave cohort by 12 months to September 2021, albeit leaving around 350 firms – representing 3,600 counterpart relationships – to comply by September 20202.
Prior to the July announcement, ISDA warned the final phases of the roll-out would lead to an “untenable rush of demand on market resources” due to the volume of firms impacted. “This will result in significant operational and technology builds in a relatively short space of time,” the trade association observed.
For global banks and brokers, posting initial margin (IM) under UMR involved a considerable upgrade of existing processes. But migration of regulatory IM to the buy-side introduces multiple new issues and requirements, encompassing documentation, segregation and custodial relationships, collateral management and funding, margin calculation, and dispute management processes.
The ability to collaborate and communicate effectively with a wide set of counterparties will not only help firms resolve margin disputes and access collateral, but also support ongoing business model flexibility.
This checklist is undoubtedly daunting, but for many it’s just the tip of the iceberg. Combined with the search for yield and other regulatory priorities such as the Securities Financing Transactions Regulation, UMR is encouraging buy-side firms to undertake a fundamental inventory reappraisal. To achieve the visibility, connectivity and flexibility needed to access and optimise collateral assets on a real-time and enterprise-wide basis – both for IM purposes and to tap securities lending revenues – asset managers are exploring cost-effective supporting infrastructure options.
Even those focused in UMR deadlines face significant operational risks. With hundreds of counterparties gradually getting to grips with new margin calculation models, the volume of margin disputes is expected to multiply, especially as regulatory guidance is not always comprehensive or consistent. The sell-side has coordinated its use of margin models via process standardisation and common reconciliation middleware. But this only minimises disputes rather than eliminates them and may not be accessible to all buy-side firms. As ISDA notes, “Absent margin reconciliation services, dispute management will be an operationally burdensome and impractical task across multiple counterparty relationships.”
Traditional levels of reliance on the sell-side are no longer an option. Not only are regulators scrutinising outsourcing arrangements more closely; brokers may have less appetite or capacity to get involved in the minutiae of complex resolution processes, given the scope for miscalculation, disagreement and conflict.
Further, developments in derivatives regulation reflect a wider new reality in which asset managers are taking greater ownership of their operating infrastructures, investing wisely in a flexible, open but robust underlying frameworks that allow them to partner with best-of-breed technology providers. This can help to implement solutions to standardise the margin calculation process, ideally as part of an end-to-end workflow that also tackles the exceptions and disputes that inevitably arise despite attempts at full automation. The ability to collaborate and communicate effectively with a wide set of counterparties will not only help firms resolve margin disputes and access collateral, but also support ongoing business model flexibility.
Strategic investments in technology, operations and infrastructure can address these regulatory challenges, but also position asset managers to deliver long-term value to investors. Before long, they might even starting paying for their own drinks.
1. Compliance with UMR started in September 2016 and will complete with the sixth wave in September 2021.
2. According to an analysis by the International Swaps and Derivatives Association (ISDA).