What would be the consequences of banning derivatives from the asset management industry? Alessandro Beber, a Professor in Finance at Cass Business School conducted a ‘what-if’ analysis on the consequences for asset managers and their customers if such a ban on derivatives were enforced. He talks to DerivSource about his findings from this ‘finance-fiction’ study.
Q. What prompted you to review the consequences of a derivatives ban?
A. As a Professor in Finance at Cass Business School, many of my teachings focus on derivatives and specifically how derivatives may be used to improve performance, reduce risk and, for non- financial fund managers, improve profit and loss accounts. Recently we have been looking at the impact of regulation post the financial crisis and the problems associated with the short selling ban imposed in many countries in 2008. In view of the of the proposed regulation and supported by strong interest in this topic from the Association of French Fund Managers, we thought a review of the impact of banning derivatives would be well suited to share within the public domain.
Q. What made you take on research in the ‘finance-fiction’ method and the ‘what- if’ scenario as opposed to the traditional approach of market analysis?
A. Students appreciate two features of what you are teaching, topics which are both rigorously researched and relevant. How the asset management industry copes with the short selling ban is the most effective way to highlight the effects of some regulations. In cases where the ban was enacted, as researchers we could see what the effects would be, as there is no ban on derivatives yet we are trying to imagine what would happen, which is why we use rigorous research and teaching.
Q. How do you conduct the ‘what- if’ analysis and can you offer some examples which you used when you wrote your research paper?
A. The ‘what- if’ analysis starts with what asset managers do with derivatives and why they are using them. To establish how widespread the use of derivatives is we conducted a survey of French fund managers. More than 50% of the funds we talked to were using derivatives and we discovered similar proportions in Spain, Italy and a slightly larger proportion in the US. When asking fund managers in our survey and looking at other academic studies we found that derivatives are used to manage risk, which is striking because if you think about derivatives from the mainstream point of view they are associated with big losses, large capacities and they are speculative. We examined how investment managers manage risk with derivatives and when buying a derivative on a specific market they get the benefits of diversification. If derivatives were banned fund managers would still be able to buy stocks and futures although the performance of the fund could suffer as costs or the risks of the fund may be higher because managers decide not to perform risk management activities. The larger funds will still use derivatives however, the smaller funds cannot rely on large economies of scale when implementing alternative risk management strategies. Banning derivatives in asset management would penalise the end investor through higher transaction costs or suboptimal risk management strategies.
Q. Do your findings conclude that the end investor or the people who think derivatives are just doom and gloom actually pay more fees?
A. That is correct. In the end the evidence we gathered suggests that derivatives are used as risk management tools and if you reduce the tools set of the risk manager you make it more expensive; either the risk manager will not use derivatives or will pass on the cost to the end investor.
Q. Are there any surprising findings or scenarios that came up throughout your research and ‘what- if’ analysis?
A. The most surprising finding relates to exotic or complex instruments. At first sight one might think regulators wanting to ban exotic instruments would be a good move, but in actual fact, these instruments are really not exotic for the users but only complicated for the non-expert users. By banning exotic instruments you are reducing the risk management tool set that asset managers can use, and you must assume that the fund manager is sophisticated enough to understand these instruments and so he should be allowed to use them because they are the cost effective tools. It would be beneficial from an academic or research stand point if some countries were to ban the use of derivatives in the asset management industry and to empirically and rigorously measure the affects of this. In academic research we are only able to compare funds which are using derivatives and those which are not. The evidence is present for US funds, though it is 10 years old so not that recent however, the conclusion was there is no sign that the funds using derivatives are more risky that those which do not. This helps to dispel the notion that derivatives are used to take bets. Also, a mainstream individual or end investor is not an expert in the use of these types of instruments so would not use them to ‘take bets’ in the market despite mainstream claims that these instruments are used for this purpose. The available evidence shows that this type of use for betting is simply not happening.
Q. If you were to have a conversation with a mainstream investor and a portfolio manager at a fund house what points of advice would you give?
A. To the financial investor I would say that if he doesn’t fully understand what the asset manager is using in his portfolio this shouldn’t worry him too much as there are strict regulations on managing risk for asset managers; it is very hard for an asset manager to use derivatives in a way that is not appropriate. I would also explain to an end investor that derivatives are used to manage risk so if they are banned, fees will be higher or performance of the fund will be lower.
For the fund managers, I would explain that it is vital for them to inform public opinion about the way they use derivatives as these instruments are still relatively opaque. Our research highlights this a little but fund managers should play their part as well in informing the public.
Q. With ongoing regulatory reform would you suggest to regulators that the solution is not to ban derivatives?
A. My point of view is very clear – banning derivatives of any sort from the asset management industry is a very bad idea. Regulators have the power to require asset managers to be more transparent. And even if you think the asset manager is not sophisticated enough to understand the consequences of the risks in their portfolios, the regulator is skilled enough to warn of the dangers. As long as they know what funds are doing that should be enough. Therefore, I am more in favour of regulation which reduces opaqueness; it doesn’t need to be transparency to the final investor but to the regulator because the regulator should be able to understand when something is not right for the end investor.
Q. Would you agree that the requirements under EMIR to report swaps for fund managers and the collateral information is a step in the right direction to give transparency to the regulators?
A. Yes, I think this is the way forward; all the bans were bad for the market in the end, with the short selling ban there was very strong empirical evidence and this transparency requirement though costly for asset managers, does not prevent them from carrying out their financial duties.
