The cost of clearing and collateralising swaps is an effective deterrent to using them
The management of collateral was never a high priority for fund managers. In the pre-crisis era, they left cash and securities in custody with a prime broker, and let the equity finance, synthetic finance and futures clearing arms of the investment bank do whatever was necessary. They may not have managed their financing costs aggressively, or secured the optimal returns owing to a net provider of liquidity to the cash and securities markets, but they did not have to do the work either. Indeed, the greater the surplus cash and securities a manager had, the less sophisticated a manager needed to be in managing assets as collateral.
It is the mandatory clearing of swaps that is for the first time forcing all managers to address collateral as a fund management cost and discipline in its own right. Many managers are already re-negotiating their Credit Support Annexes (CSAs) with their prime brokers to ensure that the eligible collateral includes what they own and are likely to own, so they can not only meet higher demand for collateral, but optimise its use across trades cleared via central counterparty clearing houses (CCPs, which take initial as well as variation margin) and prime brokers.
But managing collateral well requires more than a new set of CSAs. It demands technical knowledge, accurate information about collateral owned, owed and expected, fast and sophisticated systems to select and move assets repeatedly throughout the day, an ability to turn securities into cash in the repo market, an efficient operational infrastructure to settle the various transactions, and senior management support to invest in the technology, services and people required. Only the largest institutional managers can command these. With eligible collateral measured in trillions of dollars, collateral management is a business of scale and operational efficiency, neither of which is a natural habitat of any but the largest fund managers.
It follows that any manager using collateralised markets – including repo and swaps – will need to outsource the work to a custodian, prime broker, fund administrator or IT vendor. This will cost fund managers money, at a time when the scale of their own need for collateral management services is still unclear, and their costs are being squeezed just as aggressively as any firm on the sell-side of the securities industry. So far, there is not much sign that they are incurring that cost. Custodian and investment banks in particular have invested heavily in systems to support buy-side collateral management, but have yet to attract much business.
One reason for this is that bankers tend to assume that fund managers will manage collateral in the same way as a bank. Though the increased focus on asset safety and segregation is changing behaviour on the sell-side, banks have effectively managed proprietary and client assets as a single pool of collateral. Fund managers, on the other hand, are obliged to manage and report the assets belonging to each fund separately. This introduces a high and intricate degree of complexity, which will only increase when managers are also obliged to report every swap trade to one or more of the new breed of trade information warehouses.
But the main reason for the relative lack of activity may well be that fund managers have decided the costs of operating in cleared swaps markets are simply too great. After all, they will be paying a clearing broker, a tri-party agent and a custodian bank as well as a CCP, to say nothing of the additional costs of turning securities into cash to meet margin calls, and have many fewer opportunities to net margin across offsetting positions. Those additional costs, unmitigated by netting, might easily amount to anywhere between 30 and 50 basis points. It can be argued that this figure is no more than an explicit version of a cost that was previously implicit. But it is high enough to explain the growing interest in potentially cheaper alternatives (which may or may not include futurised swaps) and the rationalisation of investment portfolios to restrict or even minimise the use of swaps. That may well be the outcome the regulators are seeking.