130/30 Funds – The Operational Complexities of OTC Derivatives
Dr Christopher Sier
Director
Alpha Financial Markets Consulting
Chris.sier@alphafmc.com
+44 7976 887 642
© Alpha Financial Markets Consulting Limited 2008
Content
 Introduction
 Physical Shorting
 Synthetic Shorting and the Use of Derivatives
 Derivative Operating Model Options
 Position Substitution for Exchange-Traded Derivatives
 Build / Buy / Internalise
 Partial Outsourcing
– The Use of Collateral Management
– Intermediation
 Full Outsourcing
– The Costs
2
There is evidence to suggest that the ‘Alternative’ and ‘Traditional’ fund manager spaces are
starting to merge
50%
450
45%
400
Proportion of Assets within Equity Funds
Alternative Funds, 2000 = 100
40%
Proportion of Total AUM in Dublin
350
300
250
200
150
Equity Funds, 2000 = 100
100
50
35%
30%
25%
20%
15%
Proportion of Assets within Alternative Funds
10%
5%
0%
0
2000
2001
2002
2003
2004
2005
2006
2000
2007
Growth of Alternative Funds and Equity Funds in Dublin, based on number of new
registrations. Source: Fitzrovia
2001
2002
2003
2004
2005
2006
2007
The decrease in the proportion of assets within equity funds and accelerating growth of
alternatives. Source: Fitzrovia

Legislation such as UCITS III has allowed Traditional managers to enter the asset management space occupied by Hedge Funds,
and visa versa

It may be that Hedge Funds are catching on quicker as they seek revenues from Retail Investors

I will concentrate on the regulated space and focus on the operational issues involved with:


Synthetic short-selling

The wider use of derivatives
I will mention the issues involved with Covered Physical Shorting
3
Gearing options
Gearing
Option
Physical Long
Physical Short
Uncovered
Shorting
Physical Long
Synthetic Short
Synthetic Long
Synthetic Short
Other OTC intensive
Strategies
Covered
Shorting
US Model
Predominant
Location
Dublin Model
Luxembourg Model
Instrument
Choices
•Equity Swaps
•CFDs
•Single Stock Futures
•Total Return Swaps
•Equity Swaps
•CFDs
•Single Stock Futures
•Total Return Swaps
•CDS (single name,
basket, index...etc)
•IRS
•INS
•Cross Currency Swaps
•...etc
4
Content
 Introduction
 Physical Shorting
 Synthetic Shorting and the Use of Derivatives
 Derivative Operating Model Options
 Position Substitution for Exchange-Traded Derivatives
 Build / Buy / Internalise
 Partial Outsourcing
– The Use of Collateral Management
– Intermediation
 Full Outsourcing
– The Costs
5
The issues with Physical Shorting


Uncovered (‘naked’) vs Covered Short Selling

Uncovered – An uncovered short sale is where the investor has no right to the security at the time of agreeing to the sale. The investor will
then seek to purchase the security before delivery is required

Covered - Short positions are covered through stock borrowing arrangements
Uncovered Short Selling is definitely not permitted in Europe (Regulation 72 of UCITS Regulations 2003)


NOTE: There is an ongoing debate in the US that Uncovered Short Selling is socially valuable as it facilitates competition in the market for
securities lending as opposed to introducing excess volatility into stock prices (Source: Regulation Magazine, Spring 2008, “The Economics
of Naked Short Selling”)
Covered Short Selling was briefly permitted until recently in Europe (Dublin), but even this has been suspended (from 25 th April 2008)
pending an EU investigation and is unlikely to be re-instated
Covered Short Selling requires Asset Managers to deal with several thorny issues:



Accounting:

The leverage generated, as measured by global exposure, must be monitored to check it falls within permitted limits. However, compliance
and accounting systems are often unable to cope with short positions

Need to account for Dividends as these still belong to the broker from which you are borrowing

Accounting for ‘excess borrow’ can be a real problem in situations where anticipated shorting has not met expectations and the underlying
has been borrowed up-front to excess
Risk Management:

Some UCITS III funds require VaR calculations and some (older) risk management systems cannot cope

Stress testing when using short positions can be complex
Financing: The lender can re-call the stock at short notice, or require an increase to the financing cost of the loan (e.g. if the stock
goes ‘special’) without notice
6
Content
 Introduction
 Physical Shorting
 Synthetic Shorting and the Use of Derivatives
 Derivative Operating Model Options
 Position Substitution for Exchange-Traded Derivatives
 Build / Buy / Internalise
 Partial Outsourcing
– The Use of Collateral Management
– Intermediation
 Full Outsourcing
– The Costs
7
NOTE - Strategies other than 130/30 also drive the use of complex instruments
Strategy
Derivative Instruments Typically Used
Market Neutral
Securities Borrowing, Forwards
Managed Futures
ETDs, Options
Emerging Markets
IRS’, CDS’
Convertible Arbitrage
Convertible Bonds, Securities Borrowing, Equity Swaps, ETDs, Options
Fixed Income Arbitrage
CDOs, Mortgage-backed Securities
Credit Hedge
CDS’, IRS’, Cross Currency Swaps, INS
Distressed Debt/High Yield
High Yield Bonds, Securities Borrowing, CDS’
Global Macro
Securities Borrowing, Currency Forwards
Structured Products
Leveraged Loans, Total Return Swaps
Fund of Funds
Hedge Funds, Collective Instruments, Private Equity/VC, Real Estate,
Currency Forwards
130/30
Equity Swaps, CFDs, Futures, Total Return Swaps
Source: Derivatives Module from Annual Alpha FMC Investment Operations Benchmark
8
OTCs require new processes, many of which are unfamiliar and risky to carry out for most (vanilla)
Asset Manager Operations
PROCESS
ISSUE facing Investment Manager
CONCLUSION
•Gathering data can be difficult and expensive
•Each new instrument type requires bespoke set-up / new data feeds...etc
NEW and DIFFICULT
•ISDA and CSA creation and management is a tricky and manual business
NEW and DIFFICULT
•There are short-form STP solutions available, but long-form confirmations require
specific skill-sets and are highly manual
NEW and DIFFICULT
•Again, this will require expansion of extant operational and systemic capabilities
Extension of process
•Compliance rules will need to be examined closely to ensure that, for example, the
correct counterparty is being assessed for aggregate exposure
Extension of process
•Another new set of skills to acquire
NEW and DIFFICULT
•New skills, systems and data sources need
NEW and DIFFICULT
Valuation / Accounting
•Current crop of accounting systems struggle and shoe-horning may be necessary
Extension of process
Collateral Management
•Again, new skills, systems and data required
NEW and DIFFICULT
•Cash movements will increase markedly, not just as part of the life-cycle process of
some instruments, but also as a result of collateral calls
Extension of process
•Reconciliations will be more frequent and more complicated
Extension of process
•New skills and systems needed to generate meaningful analysis
NEW and DIFFICULT
Trade Capture /
Instrument Set Up
Document Management
Confirmations
Position Management
Compliance
Event / Life Cycle
Management
Model-Based Pricing
Cash Movement
Instruction
Reconciliations
Performance and
Reporting
9
Unless you have very sophisticated operations, each new instrument presents a fresh set of
challenges
Physical Long
Synthetic Short
Synthetic
Gearing
Option
Required
Operational
Processes
Synthetic Long
Synthetic Short
Other OTC intensive
Strategies
Trade Capture /
Instrument Set Up
Document Management
Confirmations
Position Management
Compliance
In effect, EVERY
operational box must be
filled with something
Event / Life Cycle
Management
Model-Based Pricing
Valuation / Accounting
Collateral Management
Cash Movement
Instruction
Reconciliations
Performance and
Reporting
Instrument
Choices
10
Many Managers struggle with these new process
Confirmation times
Average time to fully confirm (days)
40
35
30
25
20
2006
15
2007
10
5
0
Swaps Swaps Swaps - CDS Index
OTC
Swaps Equity Commodity Inflation
Options Currency
(Puts/Calls)
Swaps Total
Return
Swaption CDS Single Swaps - CDS Basket
Name
Interest
Rate
 Average confirmation times fell in 2007 but some instruments remain unconfirmed for long periods (in some cases over 60 days)
*Source: Derivatives Module from Annual Alpha FMC Investment Operations Benchmark
11
Reliance on counterparty
CF/Eq CFD: Margin/Collatral
CF/Eq CFD: Valuations
CF/Eq CFD: Exposure Reporting
2006
OTC F/O: Margin/Collatral
OTC F/O: Valuations
OTC F/O: Exposure Reporting
CDS: Margin/Collatral
CDS: Valuations
CDS: Exposure Reporting
Primarily reliant on counterparty
Partially reliant on counterparty
Simple Swaps: Margin/Collatral
Simple Swaps: Valuations
Simple Swaps: Exposure Reporting
No reliance on counterparty
N/A
Complex Swaps: #Margin/Collatral
Complex Swaps: Valuations
Complex Swaps: Exposure Reporting
CDO: Margin/Collatral
CDO: Valuations
CDO: Exposure Reporting
0%
10%
20%
30%
40%
50%
60%
70%
80%
90%
100%
CF/Eq CFD: Margin/Collatral
CF/Eq CFD: Valuations
CF/Eq CFD: Exposure Reporting
2007
OTC F/O: Margin/Collatral
OTC F/O: Valuations
OTC F/O: Exposure Reporting
CDS: Margin/Collatral
CDS: Valuations
CDS: Exposure Reporting
Primarily reliant on counterparty
Partially reliant on counterparty
Simple Swaps: Margin/Collatral
Simple Swaps: Valuations
Simple Swaps: Exposure Reporting
No reliance on counterparty
N/A
Complex Swaps: #Margin/Collatral
Complex Swaps: Valuations
Complex Swaps: Exposure Reporting
CDO: Margin/Collatral
CDO: Valuations
CDO: Exposure Reporting
0%
10%
20%
30%
40%
50%
60%
70%
80%
90%
100%
 The extent to which participants relied on their counterparties for valuations, margining and exposure reporting fell in 2007 (i.e. A greater
proportion of ‘green’ above) but is still considerable
*Source: Derivatives Module from Annual Alpha FMC Investment Operations Benchmark
12
Collateralisation
Degree of collateralisation (average across group)
90%
80%
70%
60%
50%
40%
2006
30%
2007
20%
10%
0%
Swaps Equity
Swaps Commodity
Swaps Inflation
CDS Index
OTC
Options
Swaps Swaps Swaption
Currency Total Return
CDS Single
Name
Swaps Interest
Rate
 The degree of collateralisation increased from 2006 to 2007, which is good. However, it was still not 100% which was the result of the
tactical use of uncollateralised positions, which is a very risky approach, especially in the current markets
*Source: Derivatives Module from Annual Alpha FMC Investment Operations Benchmark
13
Not all derivatives are equally complex to manage operationally...and the bad news is that Total
Return Swaps are particularly difficult
2007 Alpha Operational Benchmarking Study - Consensus Derivatives Complexity Model
Ongoing Management and Administering Complexity Rating
250
CDO
200
Sw aps Total Return
CDS Index
150
Sw aps - Inflation
CDS Single Name;
Sw aps - Currency;
Sw aps Commodity
Sw aps - Equity;
Sw aption
Sw aps - IR
OTC Futures; OTC Options
100
ET Options; Warrants
50
ET Futures
Currency
Forw ard
Equity CFDs
OTC Forw ard / Non
Deliverable Forw ard
0
0
5
10
15
20
25
30
35
40
Trade, Confirm, Initial Settle & Close-Out Complexity Rating
This information was derived by holding meetings with the heads of derivative processing for each participant in the
Alpha FMC Derivatives Benchmark*, forming a consensus view
*Source: Derivatives Module from Annual Alpha FMC Investment Operations Benchmark
14
45
Aside - Other data collected as part of Alpha’s Derivatives Benchmark

Demographics data to allow segmentation of client base – sample size currently 19 Investment Managers. The goal is to significantly
expand the size of the study

Volumes of each derivative instrument type traded and held

Strategies used

Operating model description, including systems used

All costs, both direct and indirect, relating specifically to derivatives

Degree of STP

Size and frequency of cash breaks

Planned developments, often showing the disconnect between front office and operational strategies

All this data year on year to show progression, in many cases at the individual client level as well as at the ‘industry’ level

One significant derived finding, based upon the empirical data collected, is that there is a strong inverse correlation between volumes
of derivatives used and the unit cost of operationally managing derivatives...but more on this later
15
All these new operational requirements take time to build and learn, and that means risk and
opportunity cost, especially when volumes grow (as they most definitely will)
Operational Capabilities
Target
Current
Time
Opportunity Cost
3.
Additional opportunity cost
The additional opportunity cost historically has been a function of:
1. Lack of adequate skills in the buy-side
2. Poor strategic platform coverage
Poor capabilities of the outsource provider community, coupled with the complexity
of working with a provider that might object to you going elsewhere for best-ofbreed derivatives processing
But the market is changing
16
Content
 Introduction
 Physical Shorting
 Synthetic Shorting and the Use of Derivatives
 Derivative Operating Model Options
 Position Substitution for Exchange-Traded Derivatives
 Build / Buy / Internalise
 Partial Outsourcing
– The Use of Collateral Management
– Intermediation
 Full Outsourcing
– The Costs
17
Position substitution from OTC to Exchange Traded Derivatives
It is my belief that, in some cases, Managers use OTC Derivatives unnecessarily, given the ‘fully loaded’ risk and cost of execution and management

In other words, if the full OPERATIONAL RISK and COST are considered Managers might, if correctly informed, seek alternative ways of
achieving similar financial engineering and exposure objectives

Interestingly, one upshot of the increasing awareness of the extremes of operational risk involved in using OTC Derivatives has given
Operations a say in vetoing or delaying new and more complex instrument types. Fund Managers are therefore, in some cases, being
constrained in their desires to use new instrument types and this is seen as a risk (and therefore driver for operational sophistication) by
some Asset Managers, who fear an exodus of key Fund Managers if they are not allowed to ‘play’

Is it possible, in some instances, to substitute Exchange Traded Derivatives for OTCs?
What are the advantages of ETDs?

Move from single counterparty risk to central counterparty risk

Exchanges also offer large operational advantages:

No expensive and difficult-to-find independent valuations required that may, or may not, reflect the price someone is prepared to pay

No (manual) confirmation process required

No (manual) broker reconciliations required

No collateral calculations required – margin posted automatically
In the future, the key may be to migrate OTCs onto exchange and CCP as and when the technology becomes available. Unfortunately, there may be
systemic reasons why this doesn't happen quickly

Who will help you? Your broker won’t be interested in ETD business when high margin OTC contracts are much more profitable

Brokers will need to AGREE and build the exchange and the OTC market will need to standardise (contract terms...etc) before this will
happen

Collateral disputes and a single agreed source of valuations may blow the whole idea out of the water
18
Content
 Introduction
 Physical Shorting
 Synthetic Shorting and the Use of Derivatives
 Derivative Operating Model Options
 Position Substitution for Exchange-Traded Derivatives
 Build / Buy / Internalise
 Partial Outsourcing
– The Use of Collateral Management
– Intermediation
 Full Outsourcing
– The Costs
19
Full in-source solution – train / build / buy
In-source Solution
PROS

Total control over your Operating Model

Can develop team from trusted internal resources

IT:

BUILD platform: Can build bespoke and flexible IT solution to meet current/future requirements

BUY platform: Priority over system /service developments
CONS



Small reduction on additional
opportunity cost
PEOPLE and PROCESS:

Training can take a long time and requires commitment

Once trained, key resources may leave

Buying staff in can also be expensive (salaries for people with OTC experience are often £100k+)
IT BUILD:

Complexity and lack of appropriate resource leads to difficulties segmenting requirements and defining processes

Maintenance costs

Fixed costs

100% of market risk in-house
IT BUY:

Capital outlay – could be £millions

Current lack of end-to-end solution that is both buy-side specific and affordable
THE GOOD NEWS

Vendors are working on:

Tailoring their solutions to the buy-side and providing more affordable asp solutions (e.g. Summit ASP, Calypso ASP)

Building buy-side specific platforms that fit IMs needs more closely (e.g. DSTi ‘Investment Control’)
20
Content
 Introduction
 Physical Shorting
 Synthetic Shorting and the Use of Derivatives
 Derivative Operating Model Options
 Position Substitution for Exchange-Traded Derivatives
 Build / Buy / Internalise
 Partial Outsourcing
– The Use of Collateral Management
– Intermediation
 Full Outsourcing
– The Costs
21
Blended solution - partial in-/out-source (reducing internal build)
PROS

Gain the flexibility to pick-and-mix components from different outsource providers according to cost and service levels
Blended Solution
CONS

Tricky to implement

Requires robust links/multiple interfaces to be built between each supplier

Potential delays to NAV timelines

Potentially more expensive – currently no scaling of costs

Multiple SLAs and contracts to manage
Increased reduction on additional
opportunity cost
THE PRACTICALITIES

The trick is to:

Know what you want and NEED

Compile a prioritised list of wins

Understand the comparative strengths and weaknesses of each provider and know their development plans

Careful thought needs to go into picking what you want to outsource and what you want to keep

Two models I have seen are:


Outsource collateral management (e.g. JPMorgan DCM) as this can cover off some of the tougher processes:
–
Model-based pricing
–
By default and to a great extent Event / Lifecycle Management, Position Management and Reconciliations
–
An internal team will need to be built around the residual processes like confirmations
Use intermediation by a Prime Broker (e.g. any that will do it at a reasonable price point) which will:
–
Reduce the amount of manual work around processes like confirmations by reducing the number of counterparties
–
Requires building an internal collateral team and finding an alternative source of valuations
22
Intermediation

Prime broker acts as single counterparty facing the Asset Manager through ‘give-up’ arrangements with other counterparties. Asset
Manager still free to trade with other brokers

Advantages:


Reduces number of counterparties (and CSAs) dramatically, especially if the Asset Manager has a complex set of underlying legal entities

Reduced operational complexity as only one set of confirmations / reconciliations...etc
Disadvantages:



Exposed to single counterparty risks:
–
Broker could get to know Asset Manager’s book
–
Re-rating risk could impact financing costs
–
Potentially EXPENSIVE. Give-up fees can take the costs into £millions for an Asset Manager active in the OTC space
–
Minimum fees and monthly rolling contracts often apply
You will still need to build a collateral management operation (or outsource). Building an internal collateral operation is now less complex
because of the greatly reduced numbers of counterparty relationships. However, the key issues will remain:
–
Little or no internal experience or expertise and so finding or training staff is necessary
–
Large amounts of complex data required for OTC valuations and often a spreadsheet-managed process might lead to an
overdependence on the counterparty prices
–
Stock availability may be compromised as the complexity of internal process and poor communication may mean front office is not
aware that a security has been posted as collateral
–
How can the cost of cash collateral be mitigated, especially if rates prescribed in the CSAs cannot be matched?
–
Rehypothecation?
There are other intermediation models with key differentiators: Use the supplier as the registered entity from a sophisticated UCITS III
perspective. This will allow you to run 130/30 strategies without jumping through the arduous regulatory hoops required for
sophisticated registration; off-balance sheet
23
Collateral Management plus independent valuations

Advantages of outsourcing

Access to experienced operations and staff

Cash collateral rates more likely to be met

Wide range of eligible collateral assets

Efficient tracking of collateral improving liquidity through long-box management

Efficient CSA management

Reduced capital outlay (to buy a CM system could cost up to £1mn inc implementation) and zero maintenance costs

If you choose the right provider:




–
STP into the cash and securities settlement systems
–
Independent valuations
–
Rehypothecation
By default, you get a second order reconciliations, confirmations and life-cycle management process
Three principle players in the outsource field:

JPMorgan DCM

BNY Mellon (Colline)

Northern Trust (Colline)
The costs are often based around three components:

Per CSA fee

BPs charge for collateral assets under custody

Rehypothecation charge
Asset Managers will still need an internal operation to deal with:

Reconciliations

Confirmations

Valuations (full, or random selection for compliance purposes)

Collateral dispute management
Collateral Management is NOT a panacea for counterparty risk
24
Content
 Introduction
 Physical Shorting
 Synthetic Shorting and the Use of Derivatives
 Derivative Operating Model Options
 Position Substitution for Exchange-Traded Derivatives
 Build / Buy / Internalise
 Partial Outsourcing
– The Use of Collateral Management
– Intermediation
 Full Outsourcing
– The Costs
25
Full derivatives out-source, end-to-end (minimising internal build)
Outsource Solution
PROS

Potential access to a wider group of services and a bundled offering may lead to reduced rates

High capital and fixed costs moving to variable costs

Ultimately, saving money by:


Exploiting the economics of scale of the outsource provider (see Conclusion)

Undertaking financial engineering in order to structure costs to suit the business

Exploit scope and expertise of outsource provider
CURRENLTY most likely maximum
reduction on additional opportunity cost
Sharing risk of service with other outsourcees
CONS

Most providers up to now have had some key weaknesses, or no capability at all:

Trade Capture / Instrument Set Up - Onboarding of new instruments will be prioritised on a key client basis

Document Management - Most Service Providers are not interested

Confirmations - Long-form / Paper confirmations are usually not supported

Event / Life Cycle Management - If you go into exotics (inflation, mortality,…) then event data may be lacking

Model-Based Pricing - Models may be inconsistent so you may end up seeking alternative pricing sources

Collateral Management - Best-in-breed is a stand-alone service in its own right

Reconciliations - Many Service Providers are reluctant to deal with counterparties on your behalf
THE GOOD NEWS

There is emergent capability amongst the Service Providers (e.g. Societe Generale Security Services, GlobeOp,...)

There is extant STP capability amongst the Investment Banks, but convincing them to act as a Service Provider could be tough (non-core,
expose book to market maker, good Chinese wall needed, no requirement for balance sheet/leverage)

However, each of the providers has both strengths and weaknesses – but each has DIFFERENT strengths and weaknesses!

The trick is to understand the comparative strengths and weaknesses of each provider and know their development plans
26
And even if you outsource everything, you will still need to have some internalised operations



Relationship / vendor management

Gathering KPI data

Managing the SLAs (including service credits, where applicable)

Driving change programmes with the Service Provider

Tariff renegotiation

Vendor management is a thankless task if the provider is rubbish (you get hit from both sides of the fence)
Dispute resolution

Counterparty valuation disputes

Collateral disputes
Compliance and risk management:

Random OTC valuation checking at a minimum

Consistent checking (or blanket checking) is known – involves complete replication of the prices on a daily basis

Ultimately, a thin middle office will still be needed

Data from the Alpha FMC Benchmark shows that this required internal capability will equal, at a minimum, approximately 20% of the
total fully-loaded annual derivatives budget
27
Content
 Introduction
 Physical Shorting
 Synthetic Shorting and the Use of Derivatives
 Derivative Operating Model Options
 Position Substitution for Exchange-Traded Derivatives
 Build / Buy / Internalise
 Partial Outsourcing
– The Use of Collateral Management
– Intermediation
 Full Outsourcing
– The Costs
28
There are considerable economies of scale to be found at higher derivative volumes

Zone A – Highly manual environment resulting in a high cost per derivative unit

Zone B – Asset Managers face the decision on how best to process increasing derivative volumes. As volumes increase, managers will be unable to
operate in a manual environment and so will need to adopt an operating model to automate trading

Zone C – Cost per trade decreases as back offices are able to push through more volume with low marginal cost
How can an Asset Manager achieve economies of scale in derivative processing?
Outsource (37%
cheaper)
Blend
In-House Build
Large
Yes
Yes
Yes
Mid-Size
Yes
Maybe
No
Small / New Entrant
Yes
No
No
Asset Manager Size
Source: Derivatives Module from Annual Alpha FMC Investment Operations Benchmark
29
Derivative complexity and the impact on FTE costs
Relationship Between Number of Derivative FTE’s and Total
weighted Complexity Units
Relationship Between Cost of Derivative FTE and Total
Weighted Complexity Units
18
140
16
120
Internal Direct Cost per FTE (£000s)
# derivative administration FTEs
14
12
10
8
6
100
80
60
40
4
20
2
■ Insourced
■ Outsourced
0
■ Insourced
■ Outsourced
0
0
500
1000
1500
# weighted complexity units (000s)
2000
2500
0
500
1000
1500
2000
2500
# weighted complexity units (000s)
 The scale curves above show that both the volume of FTEs required and the cost of the FTEs increases as the volume and complexity
of instruments increases
 There is a noticeable scale economy in required headcount (shown by the indicative trend line) for both insourced STP operations and
outsourced operations as volume increases. This partly explains the scale curve for processing costs
All data taken from the Alpha FMC annual Investment Operations benchmark
Questions?