Derivatives are moving from the margins to the mainstream of portfolio management, but managing them in a fragmented regulatory environment can be a challenge.

By Brian Dunton, Head of Instrument Engineering, Eagle Investment Systems

In recent years, derivatives have moved from a niche asset class on the periphery of investment management to everyday tools of the trade for even the most conservative asset managers, as they look to enhance performance and manage risk. It’s not only that a larger number of firms hold derivatives, but there has also been dramatic growth in the volumes of derivatives being held. Where in the past, investment management firms may have held three to five total return swaps, it’s now common to see funds that hold nothing but total return swaps. The regulatory framework and processes to manage them, however, have failed to keep pace with the rapid changes in the industry while attempts at standardization have stalled.

The 2009 G20 meeting painted a “future state” picture of global harmonization for derivatives clearing and regulatory reporting, resulting in increased transparency within the derivatives market. Standardized identifiers would be the norm and would be universally adopted. However, seven years later the markets are becoming more fragmented and the picture is one of global dis-harmonization, rather than global consensus. Complex cross-border transactions can present thorny legal jurisdictional issues while reporting requirements are fragmented. Take MiFID II for example: in providing the personal information it asks for, asset managers may actually be breaching privacy laws in countries like South Korea.

There is no shortage of standards, but adoption by the asset management industry has been slow. Rarely on trade tickets is the USI provided, and even the LEI provision is patchy. More recently, there has been a push to create ISINs for OTC derivatives, although there’s a question mark over how long it might take the industry to adopt this.

If more evidence of fragmentation and disharmony were needed, the British vote to leave the EU (Brexit) has created a perfect storm of uncertainty. Questions about London’s position as the derivatives clearing capital of the world have arisen, as have questions about whether or not MiFID II remains relevant. Various European countries are already circling vulture-like while New York has also been touted as the major beneficiary. This has the potential to affect existing swap contracts and presents operational challenges for asset managers and their vendors. More recently, the Trump administration has promised everything from a full repeal of Dodd-Frank to a more targeted revamping of certain provisions creating yet more uncertainty. How these changes impact the global regulatory environment remains to be seen.

The derivatives market refuses to stand still and the requirements are constantly in flux. Against this backdrop, service providers can collaborate with clients to filter out the noise and focus on their priorities when managing and reporting on derivatives, as developing new solutions in a vacuum by guesswork and speculation is not the most productive use of either providers’ or our clients’ resources. It seems that engineering new instruments works best and delivers the most positive outcomes when it starts with the real-world needs of the client. When a client introduces a new instrument it is useful to get under the hood to see how it works, for example what the cash flows look like and how the accruals work.

In many cases that instrument may already fit in with an existing framework and can already be handled. If this is not the case, one can will look at prioritizing support for it and put best practices in place based on their requirements until the instruments can be natively supported. An example of this is an additional calculation type for a client who held a very specific flavor of a swap.

When engineering these solutions, it is important to look beyond the immediate accounting and reporting requirements. Derivatives are also of interest to performance, risk and compliance teams who have their own demands. Furthermore, there is not necessarily one true way to view derivatives. These instruments are often secondarily related to other real assets and the ability to enrich and enhance that data in different ways can be used to uncover new opportunities.

The derivatives landscape is rapidly evolving and managing these instruments can be a challenge. Against this complex background, the most meaningful analysis is achieved by building solutions based on the real-world needs and internal use cases of clients.