Regulation and macro pressures are squeezing hedge fund profits. In this contributed article, Peter Rippon, CEO of OpenGamma describes the impact of capital and margin requirements, combined with rising interest rates and competition over investment fees, and explains why margin cost needs to be a front office consideration.
In the immediate aftermath of the financial crisis, then U.S treasury secretary Henry Paulson stated there was a very real threat of regulation becoming “a wolf in sheep’s clothing.” A decade on, and regulation unquestionably remains a highly sensitive issue. The markets continue to battle for less of it, while the man on the street demands more.
One thing is for certain, no rule maker foresaw such a direct hit on returns. Unfortunately, unintended consequences of certain regulations have done just that. As a case in point, hedge fund managers can now be charged a staggering 70 per cent additional margin because of certain compliance changes, destroying returns for their investors. Specific rules on clearing houses mean they are being charged what’s called a “liquidity add-on” for large positions – amounting to a massive drag on returns. In a world where investors continue to demand more bang for their buck, this has a significant impact on a hedge fund’s performance. So why has this become such a big problem for hedge fund managers now, and crucially, what can they do to overcome it in order to drive better returns?
To answer the first half of this question, you have to look at how regulation has overhauled market structure. Pre-crisis, if you asked a hedge fund manager about derivatives margin requirements you would get a blank look. Today, implementation of new mandatory cleared and uncleared margin requirements, such as EMIR and most recently MiFID II, have significantly increased the cost of trading and consequently, contributed to reduced investor returns. From Q1 to Q4 last year, the amount of uncleared margin posted was up by almost 25 per cent (Source: ISDA). However, regulation has not been the only factor at play.
Recent macro trends such as slowly rising interest rates have had an impact. As rates rise, so too does the cost of margin. If this wasn’t enough, fund managers are in the midst of a price war on investor fees, which continue to go lower and lower. And as more flow moves into index trackers, it is also becoming harder to beat the likes of the SAP 500.
As regulatory and macro pressures mount, every basis point now counts more than ever. The difficulties are in understanding the specific nuances of new margin models, but doing so requires significant investment at a cost-conscious time for fund managers. The trouble is that that the old approaches to trading can now lead to major capital and cost inefficiencies. There are no longer simple rules of thumb that can be relied upon. Very similar trading alternatives can lead to double the cost of capital.
The old approaches to trading can now lead to major capital and cost inefficiencies. There are no longer simple rules of thumb that can be relied upon. Very similar trading alternatives can lead to double the cost of capital.
For example, the margin calculations for exchange traded, bilateral OTC and cleared OTC derivatives all vary, and so do the margin models used by every clearing broker and CCP – resulting in a complex web of methodologies that need to be understood if a fund manager is going to trade in the most efficient way. There are also further changes due to be rolled out later this year and beyond, making margin pricing even more complicated.
It has, therefore, become essential for all firms to quantify alternatives before they trade. If a fund manager can understand what is driving their margin call, changes can be made in the name of collateral management – such as different trading decisions, or different broker and CCP choices for various strategies. Fund managers used to trade on best price alone, but it now needs to be about best value overall, considering what money will be tied up as a result of margin costs. This can no longer be an afterthought.
Firms that grasp this detailed insight will be best placed to carefully manage margin. If they can get this right, potential savings can be substantial and most importantly, directly lead to freeing up more cash to drive returns. But for this to happen, fund managers do need to re-think trading and consider margin a front office problem, calculating the total cost of a trade and considering their options before execution.
Making fund managers post more cash to guard against the next financial meltdown is all very well in principle. But in practice, this equates to an enormous cost, which ultimately, will also be shouldered by the very end investors that rule makers are trying to protect. As their investors continue to scrutinise every penny, more firms will need to seek out in-depth analysis in order to reduce margin pre-trade, ensuring huge sums of money are not left on the table which could be put to work to make material returns.