Typically considered an instrument reserved for hedge funds and complex investment strategies, derivatives are becoming far more common today within investment portfolios and are increasingly desired by portfolio managers for exposure and risk management.

Typically considered an instrument reserved for hedge funds and complex investment strategies, derivatives are becoming far more common today within investment portfolios and are increasingly desired by portfolio managers for exposure and risk management.

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. But 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.

Sapient Global Markets interviewed a select group of asset managers to learn about their governance and processes supporting the assessment, implementation and trading of new derivative instrument types. These discussions centered on the following key aspects of enabling a new derivative instrument type to be operationalized within the investment management process:

• Derivatives committee structures and responsibilities
• Operational assessment and approval for new and currently traded derivative instrument types
• Risk management and controls related to derivative trading across the investment management industry
• Legal agreement management and the changing regulatory environment

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 changing derivatives landscape

Large investment managers are increasingly utilizing derivatives within their portfolios to support the introduction of new, innovative products that seek to utilize more advanced methods for interest rate, credit and currency risk management, as well as provide unique exposure opportunities potentially not offered by or accessible to competitor products. This response is motivated by both downward pressure on fees and firm profitability and concern of underperformance relative to benchmark-tracking passive strategies and exchange-traded funds.

At the macro level, the prolonged low interest rate environment has made outperformance within fixed income products particularly challenging, while the anticipation of global changes to interest rates and central bank policies has left institutional investors with few alternatives to appropriately manage the risk. Derivatives are increasingly used as an additional tool for portfolio managers seeking exposure to countries, currencies, rate differentials, etc. which is driving broader, more complex derivatives usage to become a key enabler to product innovation and the way asset managers structure portfolios. Products and strategies that more intensively use derivatives, such as unconstrained bond funds or liquid alternatives, are growing in number as another avenue for investment management firms to increase revenues, capture sophisticated investors’ assets, execute upon unique investment ideas from research teams, and manage risk more effectively. Additionally, as clients and products become more internationally distributed, more complex hedging strategies are required to reduce risk and return profits to local currency or protect against unfavorable future yield environments.

The ability to better understand and govern derivatives usage has enabled investment management firms not only to execute derivatives at a lower cost, but to also scale in terms of both volume and ability to support complexity in the form of new product launches without significantly adding to the cost. 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.

The evolution of traditionally sell-side oriented technology platforms to better cater to buy-side needs for derivative trade execution, risk and lifecycle management is an indicator of the blurring of the lines between investment managers and the dealer community. Lagging behind is investment in the onboarding and management of new derivative instrument types for client accounts, legal agreements and internal governance.

From a governance and operational support perspective, the investment management industry is beginning to consider deriva- tives as an asset class alongside equity and fixed income. Having a more complete range of derivatives capability enables asset managers to nimbly 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.

The challenge for asset managers

The standardization of the equity and fixed income markets has enabled investment managers to easily integrate new cash instruments into their various strategies. 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. Sapient Global Markets’ observations across the industry suggest that operationalizing the trading of new derivative instrument types can extend the lead time of new product introduction by three to six months. The intricacies of trading derivatives across markets require large operational assessment efforts that can often delay the inclusion of a new instrument in a portfolio, leading to missed opportunities in the market.

Investment managers are seeking a broader range of exposures using an increasingly diverse set of instruments. When Sapient Global Markets asked asset managers how they currently use derivatives and their future views on usage of derivatives within their investment products, three primary trends emerged:

1. The primary use for derivatives is for hedging purposes followed by generating alpha and liquidity management
2. The majority of investment managers stated that pooled vehicles held most of their derivative strategies and investment products, followed by institutional as well as individual separately managed accounts (SMAs)
3. All of the asset managers indicated that SMAs add a layer of complexity to implementing a new derivative instrument type due to additional legal agreements required as well as coordinating client approvals

In addition, most firms expect an increase in derivative trade volumes over the next one to three years based on market conditions and/or strategy diversification. Some firms expect sharp increases in volumes and trades as the multi-asset/sector space gains traction, while other firms expect to see unchanged volumes in anticipation of the impact of new regulations or a potential decrease in the number of trades as transactional size increases due to costs.

The current state of governance models and practices

Governance plays an integral role in onboarding and enabling a new instrument type for trading across the investment management technology and operations infrastructure. Governance is the means by which derivatives usage and operational risk can be balanced. Therefore, it is essential for firms to assess their current governance models and practices to identify strengths, weaknesses and limitations.

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. One firm implemented a more in-depth review of not only capability to trade, but education and judgment of whether or not an instrument should be traded to mitigate both operational and business risk.

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. The majority of firms review derivative usage biweekly or once a month, yet almost all said their committee convenes on an as-needed, ad hoc basis to review any new issues that arise with a portfolio manager’s new instrument request. For all the firms Sapient Global Markets interviewed, however, none felt they were fully staffed to support the onboarding of new derivative instrument types brought on by new product launches and risk and liquidity management initiatives.

Firms should also determine the level of efficiency in the current process for assessing their 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. Half of the firms stated that their governance structure is far from streamlined and that challenges and backlogs exist primarily in operations and technology. Asset managers’ sentiments included the following:

• Because discussions about trading derivatives (including new instrument types) usually occurs at the portfolio manager/trading level, by the time operations is informed, the process is already behind
• Given the number of internal and external entities and departments required to support the implementation and enable trading for a new derivative instrument type, the ability of operations to respond quickly is dramatically slowed down
• Technology is adequate with multiple workarounds in place, but does not or will not scale well with increased volumes or complexity in the future
• Technology is 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. However, major operational challenges occur in the process of assessing and approving new derivatives, managing legal agreements, meeting regulatory mandates, and achieving fast time to market for new investment products while controlling operational risk.

The struggles experienced by firms to facilitate the availability of a new derivative instrument for usage within portfolios is magnified because of the complexities of the lifecycle of derivative trading. When asked to outline their pre and post-trade process for onboarding a new derivative, asset managers revealed the following:

• Primarily 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
• Only half of the firms Sapient Global Markets spoke to have a 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

Legal Agreements

With respect to enabling the trading of a new derivative instrument type within an investment product or portfolio, legal agreements pose an interesting challenge for investment management firms. 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.

When Sapient Global Markets asked asset managers whether derivative trading in client accounts occurs under an umbrella master agreement, or their clients negotiate their own agreements, a small percentage 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. Asset managers discussed several ways the new regulatory requirements have changed the legal review and documentation process:

• 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 we already have authorization to trade, the is largely “case by case” in which 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 Sapient Global Markets’ interviews, asset managers stated that, excluding client contracts, it can take anywhere from three weeks to one year to completely onboard a new derivative instrument type.

The majority of firms also stated that most instruments 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.

In addition, the majority of firms Sapient Global Markets interviewed said they complete a full end-to-end testing of any new de- rivative instrument. However, in some cases, this testing is completed for one specific business area rather than enterprise-wide. 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 software providers. The bulk of the testing effort often ends up being on the accounting system given 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 and enable their investment professionals with a full toolkit of market access and risk management tools, the time to enable trading of a new derivative instrument type must be significantly compressed.

Revamping 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 necessary to inspire and enable the cultural change needed to support 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.

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 the majority of the investment managers interviewed 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, no investment manager was continuous improving their governance structures, suggesting that derivatives governance 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.

This article was first published in edition 5 of Rocket, our magazine. Download available Rocket editions here, and save your up to date address in your profile to to indicate your interest in receiving a printed copy of the magazine. Copies are also available to purchase and subscribe to via the shop.

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