Franklin Templeton ramps up OTC collateralization and hedges volatility.

European banks’ significant holdings of debt issued by countries on the brink of default greatly elevates their risk as counterparties, a concern Franklin Templeton Investments has mitigated by collateralizing mark-to-market exposures to them—most recently forward currency contracts.

Wylie Tollette, director of performance analysis and investment risk at Franklin Templeton Investments, noted counterparty exposure as one of several risks dogging investment managers today, including adapting to the rapidly evolving over-the-counter (OTC) derivatives market and record market volatility.

Tollette said that European banks’ lack of transparency about their holdings and insufficient write downs of troubled assets has prompted Franklin Templeton to “pull back, but not completely” in terms of transactions with those financial institutions.   One approach has been to reduce their counterparty risk.

“We started over the last year to push for collateralization of forward transactions,” Tollette said, describing the asset manager as a “very large” user of forward currency transactions.

Tollette said most institutions historically have not considered forward currency transactions to be derivatives and put them in the same low-risk “bucket” as spot currency trades, and so collateral was rarely involved. But forwards of a year or less in duration closely resemble short-term derivative contracts, such as credit-default and interest-rate swaps. Franklin Templeton uses those derivatives sparingly but has long required collateral from counterparties.

“As our success using those forwards in our investment strategies grew, and our volume of forward currency transactions grew, we started accumulating large counterparty exposures in those instruments,” Tollette said. As a result, he added, the firm saw the need to further “protect ourselves from” its bank counterparties.

Franklin Templeton began aggressively analyzing counterparty risk in 2007, after two Bear Stearns hedge funds failed. “We enhanced our existing oversight and developed a rigorous process for looking at our banks and exposures to them, “Tollette said. “We were able to largely protect ourselves from [the collapses] of Bear and Lehman Brothers.”

Collateralizing currency forwards represents another step in that process. Franklin Templeton moves collateral back and forth with its forward-currency counterparty banks, depending on the mark-to-market value of the transactions at the end of the day. If one counterparty implodes, “this would protect us for the amount we made on trades done with that institution up until the previous evening,” Tollette said.

That’s not a perfect hedge, and there are additional custodial costs associated with moving collateral back and forth. Nevertheless, currency forwards are used across a variety of the firm’s investment strategies, and collateralizing them reduces unanticipated outcomes emerging from today’s highly volatile markets.

“This is essentially what U.S. regulators are driving for by pushing swaps into centralized clearing,” Tollette said.

Market volatility also amplifies concerns stemming from rapid developments in the OTC markets. Regulators and investment-company boards have increased their scrutiny of OTC derivative use. In response, Franklin Templeton has established two committees chaired by Tollette that are mandated to ensure the necessary controls are in place to trade complex securities and credit instruments.

Eighteen months ago, said Tollette, a portfolio manager wanted to establish a small hedge using an inverse exchange traded fund (ETF), which enables wagering that a  market index will lose value. The committees nixed the investment after determining that holding the ETF for more than a day resulted in erratic performance results.

“In addition, those ETFs have significant counterparty exposure because they tend to use total return swaps to provide the leverage,” Tollette said. “Our general approach  is that  if one of our funds can’t invest in a total return swap, then it shouldn’t invest in another fund that does.”

Tollette said a third, more general risk the industry faces is that volatility is prompting long-term investors to move into what they view as risk-free investments, but no investment is without risk. Investors have flocked into Treasury bonds, for example, even though they’re bound to lose value when rates rise.

For similar reasons, retail investors have shied away from equities following financial crises beginning in 2008.

“Since 2008 each year has had its share of equity risk headlines.  The flash crash in   2010 was the scare last year that kept people worried about whether they’re being treated fairly in the market, and this year it is the European debt crisis. ” Tollette said. “But in the long term, we believe equities is where investors will have to be for at least a portion of their assets to achieve the returns they’ll need.”