Balancing Innovation and Risk Through Enhanced Derivatives Governance
Geoff Cole and Jackie Colella, Sapient Global Markets
Typically considered an instrument reserved for hedge funds and complex investment strategies, derivatives are becoming far more common today within investment portfolios. Desire for benchmark outperformance and product differentiation in a crowded marketplace has led to a marked increase in the use of derivatives within US mutual fund products and newly marketed funds that cater to the needs of the retail and institutional investor communities.
With growing competition, the shift from passive to active management, and new regulations for fund transparency, asset managers must be able to differentiate their offerings and find new ways to deliver innovative investment products ahead of the competition and at lower cost.
From a governance and operational support perspective, the investment management industry is beginning to consider derivatives as an asset class alongside equity and fixed income. Having a more complete range of derivatives capability enables asset managers to manage risk, volatility and liquidity, as well as seek and execute upon numerous investment team ideas envisioned for their clients’ portfolios. With this evolution, firms are confronting more complex issues associated with trading and managing derivatives positions and new instruments because the level of complexity and inconsistency industry-wide is greater than traditional cash securities.
Nimble governance structures can help asset managers unlock the full value of technology and operations in reducing time to market and giving portfolio managers access to a comprehensive range of tools at a reasonable, incremental cost.
In speaking with heads of derivative operations and primary derivative leads, the issues investment managers face to effectively and efficiently implement a new derivative instrument type became clear: enabling the trading of a new instrument type to quickly support a portfolio manager request, while taking into account technology restraints and mitigating operational and reputational risks requires significant due diligence and a robust yet flexible governance model to support the process.
The current state of governance models and practices
The complexities of derivatives, and firms’ disparate individual abilities to implement and manage the operational risk associated with introducing new derivatives instrument types into the investment infrastructure, exponentially increases the difficulties associated with the governance and onboarding of new derivative instruments into the front-to-back investment management infrastructure.
The investment management industry is struggling to determine the proper level of operational and legal due diligence necessary to create a level of comfort appropriate for firms to trade new derivative products while balancing investment managers’ desire to be the first to market with a new product offering that offers a unique exposure or risk management approach.
In talking to asset managers, it is apparent many firms have governance committee(s) responsible for approving the operational aspects of new instruments; however, the process for implementing the changes varies widely from firm to firm. In most cases, different committees are responsible for approving derivative usage on a portfolio or fund level, but most committees only approve operational capability in terms of whether or not the instrument can be traded operationally.
Firms should consider implementing a dedicated, fully resourced derivatives team with appropriate product knowledge and capacity levels specific to the new instruments, markets and products to be launched. This team should support the lifecycle of onboarding a new derivative instrument type, including capabilities such as legal and client services. In addition, reviews should be conducted on a regular basis.
While the majority of firms review derivative usage bi-weekly or once a month, at many firms the committee convenes on an as-needed, ad-hoc basis to review any new issues that arise with a portfolio manager’s new instrument request.
Firms should determine the level of efficiency in the current process for assessing “readiness to trade” a new instrument type. Incorporating a streamlined process to approve and implement a new derivative instrument is paramount to mitigating operational risk and reducing time to market for new products and investment strategies. In our experience, the governance structure is far from streamlined and that challenges/backlogs exist primarily in operations and technology, primarily due to:
- Derivatives trading discussions (including new instrument types) usually occur at the portfolio manager/trading level, by the time operations is informed, the process is already behind
- The number of internal and external entities and departments required to support the implementation and enable trading for a new derivative instrument type reduces the ability of operations to respond in a timely manner
- Technology is adequate with multiple workarounds in place, but does not or will not scale well with increased volumes or complexity in the future. It often the biggest inhibitor in the implementation of new derivatives
Finding the right balance
Asset managers are searching for the right balance between enabling portfolio managers and investment teams to express their investment desires through any means possible (including usage of derivatives) and achieving the optimum level of operational control and reputational risk management.
The issues experienced by firms in facilitating the availability of a new derivative is magnified by the complexities of the lifecycle of derivative trading. The pre- and post-trade process for onboarding a new derivative at asset managers can include:
- Portfolio managers, but also some product management teams, initiate the request to enable trading of a new derivative instrument type
- In few cases, automated workflows and electronic voting for approval exist detailing the change controls necessary to efficiently onboard a complex instrument
- Counterparty information was the most critical information needed to trade a new derivative instrument along with projected volumes, underliers, currencies and markets
- Very few firms have streamlined process in place for onboarding a new derivative instrument type; in most cases, many different departments are given a task with little or no accountability
The due diligence needed to manage master umbrella agreements is cumbersome and requires qualified staffing with knowledge of the intricacies of derivatives documentation. Client sophistication must also be taken into consideration to best calibrate the level of hand holding required through the documentation updates required to enable the trading of a new derivative instrument within a portfolio.
In discussions with asset managers around whether derivative trading in client accounts occurs under an umbrella master agreement, or their clients negotiate their own agreements, a small number said their clients negotiate their own agreements with counterparties. If an investment manager chooses to trade a new derivative not stipulated in the original client negotiated agreement, it may take weeks or months to have all the paperwork completed delaying capitalizing on that derivative trade.
Regulatory Implications & Constraints
The amplification of new regulatory requirements for trading and clearing of derivatives has created greater challenges with firms’ legal review and documentation processes, changing the legal review and documentation process in numerous ways:
- Additional “touch points” requiring clients to sign off on each new requirement adds weeks to months for documents to be returned
- Extra legal team resources are needed (in terms of experience and capacity) to review regulatory changes
- Most changes occur only in the documentation
- Because the regulatory environment may change such that if the firm already have authorization to trade, firms may “inform” rather than “request” approval from the client
- Regulatory mandates in Europe are especially challenges for derivatives
Balancing Time to Market with Operational Risk
In our experience, it can take anywhere from three weeks to one year to completely onboard a new derivative instrument type. Most are traded with manual workarounds without taking into account post-trade operational processing, including settlement, collateral management and even client reporting. In many cases, an instrument that is too complex for existing systems, can delay implementation to over a year and sometimes lead to the decision not to make the instrument type available to portfolio managers at all. Such cases can create a negative client experience, significantly delay new product launches and cause significant frustration for front-office personnel.
While many firms complete a full end-to-end testing of any new derivative instrument, in some cases, this testing is completed for only one specific business area. If multiple order management systems exist, there may be increased operational and business risk in the trade lifecycle if another business unit subsequently attempts to trade the newly enabled derivative instrument.
Reliance on standard vendor packages for trading and risk management may provide out-of-the-box support for most instruments, but changes to interfaces and configuration may be more complex than anticipated or require close coordination with the software providers. The bulk of the testing effort is often directed at the accounting system given its criticality for fund pricing and reporting. However there are many other links in the chain that require significant analysis and testing in order to properly enable a new derivative instrument across the front-to-back investment infrastructure.
Essentially, each new instrument request becomes a joint business and technology project, requiring scope, funding and prioritization against all other IT projects, which can also prolong the period between the request to trade and the first execution.
Improving the governance model and practices
For asset managers looking to continually innovate, introduce new products, the time to enable trading of a new derivative instrument type must be significantly compressed.
The revamping of governance models and approval processes is required to streamline, centralize and balance the time-to-market push against operational risk. Additionally, investment in workflow tools for transparency and tracking, dedicated derivatives/new instrument due diligence teams and the active involvement of operations teams is required to inspire and enable the necessary cultural change to support the usage of more complex product types.
These changes are often overlooked dimensions of a robust target operating model (TOM) initiative that can address the definition of roles, responsibilities and accountability, as well as identify opportunities for improvement and investment across a firm and integrate with the firm’s data and architecture.
As product innovation accelerates, fee and cost pressures persist and competition for assets increases, asset managers must tie all of the capabilities supporting derivatives, including legal, client service, collateral management, risk management, reporting and project management, together in the form of a nimble and responsive governance model to enable a true competitive advantage.
Improvements in governance models and practices must also take into consideration future industry, market and regulatory shifts. Specifically, asset managers should:
- Determine if using Special Investment Vehicles (SIVs) across accounts is a viable option, based on client account structure
- Understand the potential challenges and develop strategic mitigation plans to ensure BCBS 269 compliance changes for cleared versus non-cleared derivatives
- Prepare for other regulatory change focused on increasing oversight of asset managers, such as the SEC’s proposal requiring funds to report on their use of complex derivatives products
- Assess the use of off-the-shelf (cleared) derivatives to model exposure to OTC derivatives, thereby employing the most cost-effective instruments to gain the same exposure
- Define a target operating model to ensure the ability to adapt to industry changes as well as unforeseen market and regulatory fluctuations across investment, operations and technology
- Provide all personnel with appropriate derivatives knowledge through education and training
- Dedicate appropriate resources to the management and supervision of derivatives-related initiatives
Turning challenges into opportunities
As product innovation accelerates and competition for assets increases, derivatives usage will continue to grow in both volume and complexity. While most asset managers recognize this, the focus of investment and operational improvement has typically been directed towards front-to-back trade flow improvements.
In order to support increased usage of derivatives, most firms need to also refresh the governance, approval and operational due diligence for derivatives usage. Yet most have reactive governance structures, which is a major contributor to the time lag it takes to assess and approve a new derivative instrument. In addition during our research it emerged that no investment manager was continuously improving their governance structures, suggesting it has not been recognized as a vital investment area.
Asset managers need new products and outperformance to compete, differentiate and win. Derivatives are a valuable tool for product innovation and delivering outperformance in a risk controlled manner. The opportunity exists to refresh or realign governance structures to better support organization growth in accordance with derivatives usage plans. Adopting new practices for governance and operational risk management specific to derivatives can help asset managers reduce time to market and more quickly respond to portfolio managers’ needs.
2021 marked the fourth consecutive year of record-setting trading activity.
LCH SwapAgent registered over 10,000 trades in 2021, a five fold increase.
There is growing interest in actionable insights into market data.
The next focal point of the crypto market will be over-the-counter derivatives.
Overall trading volumes across all products fell 8% from 2020.