Interest rate markets have changed substantially since the financial crisis, both visibly and also less obviously in their market structure. These differences challenge asset management firms attempting to operate on behalf of their clients, especially in liability-driven investing (LDI), where the rules and market are continuing to change around them.

By David Bullen & Gavin Dixon

Interest rate (IR) markets have changed substantially since the financial crisis, both visibly and also less obviously in their market structure. These differences challenge asset management firms attempting to operate on behalf of their clients, especially in liability-driven investing (LDI), where the rules and market are continuing to change around them.  The risk management requirements of liability-driven investments challenge asset managers who turn to banks for solutions and liquidity in their desire to transfer risk on behalf of their clients. 

New factors that have yet to impact fully, such as the greater flexibility surrounding pensions, prompting elevated transfer-out requests, increases the appetite for LDI fund flexibility. However, this desire for flexibility is at odds with reduced market liquidity and the structural changes that will make flexibility more costly. The reduced market liquidity is largely a result of a reduction in bank balance sheet levels deployed behind IR market-making functions in the bond, repo and swap sectors and the general profitability of investment bank franchises.

Many of the factors at work in European IR markets also affect the US, where their implementation and, therefore, impact is generally more advanced, although the differing structures of the respective pension industries (401K v defined benefit / defined contribution) are generating different consequences.  That said, the core need in the global market for IR liability hedging remains and will be viewed with much more focus on liquidity and flexibility considerations.

Whilst the changes, current and planned, to the capital rules for banks have fundamentally changed the provision of IR market services, their full impact will only be felt in the future. Hence, there has been no massive shift away from over-the-counter (OTC) IR products yet, which some commentators mistakenly take to mean nothing has changed.

Regulations such as Basel III, especially the capital requirements within the leverage ratio rules, have significantly increased the amount of capital that banks are required to hold. This, coupled with the funding / liquidity requirements of the liquidity coverage ratio and net stable funding ratio rules, has severely restricted or indeed in some cases closed some banks’ business lines, for example repo.  Consequently, the cost of accessing these products for the end user is much higher.  In addition, price competition for end users has been affected, as fewer prime brokerage and clearing services for OTC products are now available.

As a result of the leverage ratio, or the supplementary leverage ratio as it is known in the US, banks have withdrawn from, or re-priced, their balance-sheet intensive businesses.  For firm evidence of this, one need look no further than the existence of the London Clearing House (LCH) to Chicago Mercantile Exchange (CME) ‘basis’ in cleared IR swap pricing, whereby equivalent swaps are priced differently at the two institutions.  This re-pricing phenomenon has prompted a range of new entrants to join the market: witness the arrival of non-traditional bank market-makers, hedge funds and other new market intermediaries like Citadel.  

These groups have demonstrated they are only too happy to step into new areas to provide market services and liquidity.  Given some asset managers’ view that they expect and want to pay for leverage, it seems clear that market forces will encourage and reward these new entrants.  It remains to be seen whether these attractions will be strong enough to encourage asset managers themselves to act as market-makers to any meaningful or consistent extent.  But the advent of a broader range of exchange-traded derivative (ETD) products, with their more ‘all-to-all’ friendly trading protocol, will likely help bring about this outcome. The start of clearing of OTC products, with the ensuing removal of the credit risk element post-novation to the clearing house, also directly facilitates asset managers’ access to new sources of liquidity. They can become those sources themselves or indeed trade with other asset managers in the so called ‘all-to-all’ model, the general clearing member’s involvement notwithstanding.

The repo market is a key area of change where there are already new entrants seeking to maintain liquidity, evidenced by the creation of collateral exchange efforts like DBV-X. The group’s CEO and founder, John Wilson, notes that Basel III has prompted dealers to withdraw capacity and widen spreads at a time when clients have growing collateral transformation needs.  ‘Counterparty diversification will be essential for firms wanting continued access to deep liquidity and tight spreads, mindful collateral is an asset class in its own right that can positively contribute to fund returns if actively managed,’ he said. ‘However that will need to also encompass non-traditional counterparties like other buy-side firms and corporates.’

One prediction by an asset manager recently was of the ‘death of the reverse repo market,’ given that it swells dealer balance sheets for little benefit whilst what capacity does exist is allocated according to the profitability of a client’s general derivative business rather than any fair market pricing logic.  Collateral optimisation services on a principal basis are just too expensive due to the balance sheet costs of undertaking repo business, unless carried out as agent by custodians or via the new ‘agency’ style services on collateral exchanges.

What of the drive to clear OTC derivatives mandated by the G20?  As one asset manager commented, ‘clearing is a red herring’ because it is the least significant consideration for funds, or should be. The more significant market development is Basel III and its additional capital requirements for dealers in line with the leverage of the position. 

Red herring or not, the advent of mandatory clearing has not helped. It has started to create an uneven playing field that favours trading interest-rate risk in exchange traded format, 1-day value at risk (VAR) margining (for exchange products), versus 5-day VAR (for OTC products). There are, in fact, slight variations of this with Europe being a 2 day net position for VAR and the US being 1 day gross for ETD.  Also, LCH charges 7 day VAR for client positions in OTC IR swaps. However, this still means margining for effectively the same risk profile is far cheaper for ETD versus OTC and should, over time, drive more business  towards ETD formats, both existing and new products, given best execution responsibilities under MiFID II.

OTC offers greater precision of asset-liability matching, whilst ETD offers better liquidity and transparency, suggesting both ETD and OTC interest rate risk formats will continue to co-exist.  Current thinking suggests short-term IR markets and ‘imprecise’ hedging products will be ETD format ‘owned’ whereas long-term IR markets, which provide a more precise hedging product, will remain OTC ‘owned.’ However, this does leave the increased cost squarely in the end user’s corner. 

The challenge for future liability driven investment (LDI) users of IR markets will be to decide how and where to link effectively both ETD and OTC IR markets in practical terms.

An ETD v OTC ‘link’ is therefore needed. The evolving and new sub-asset class of IR swap futures is one tangible part of providing this link.  Their form and attraction sit neatly between the precision and flexibility of OTC and the liquidity and transparency of ETD.  The enthusiasm of providers to win in this race is apparent in the crowd that has gathered: there are currently five offerings from CME, ERIS, EUREX, GMEX and ICE.  It generally takes one to two years to develop new sub-asset classes, such as swap futures, to the point at which they are widely available and liquid.  Given the legendary difficulty of establishing exchange-traded contracts, there is some urgency here for one or two of these new products to be successful:  2018 is, after all, only seven future quarterly ‘rolls’ away.

Mandated pension fund clearing in 2018 will drive pension funds and, in turn, asset managers to consider using this new and evolving asset class. Their fiduciary responsibilities for best execution and optimum collateral create a drag on their clients’ and pensioners’ monies, likely forcing them to trade this new asset class.  Generating a credible market in these new products will also drive them to lobby liquidity providers, high-frequency trading firms, brokers, investment banks and innovative exchanges to provide products that address these needs. 

Where does all this leave the traditional investment manager providing LDI services to, for example, pension funds?  The incumbent providers might not be incentivised to make the investment necessary when they have such an established market position.

As one asset manager recently commented, ‘Successful LDI managers will need to excel at accurate hedging, liquidity provision and alpha; all whilst providing stable leverage at low cost, high levels of flexibility and clear best execution ability.’  No mean feat in today’s IR market.  The LDI toolkit, in order of importance, is effectively made up of four skill areas: 

1. Getting the hedge right
2. Being liquid and flexible
3. Generating alpha
4. Minimising drag costs (e.g. clearing costs) 

The traditional means of interest rate de-risking a pension portfolio from moves in the interest-rate environment has been through the use of interest rate swaps.  These OTC derivative instruments, rightly or wrongly, became one of the bogeymen of the last financial crisis and have attracted the attentions of regulators.  This has in turn increased the cost base of OTC businesses across the board.

Investment consultants who advise pension schemes and other mandates on de-risking trades are yet to hear about or understand the full economics of new IR asset classes like swap futures. Currently, they are discounting these products as too innovative, insufficiently liquid or both.  This situation is likely to change rapidly, largely due to the impact of capital requirements on the one hand and the push to clear derivative business on the other. 

Asset management firms’ technology tends to change at a glacial pace versus that of market infrastructure and banks, so those asset managers that can position themselves correctly will have an opportunity to disrupt and enter the LDI market with a cheaper, more transparent and flexible product offering based on both ETD and OTC interest rate derivative products. 

Current IR risk-transfer markets, following changes in capital rules and regulations, are unbalanced and provide insufficient liquidity to asset managers.  Diligent best execution by asset managers will probably magnify this imbalance over time and be resolved only with the arrival of new entrants and new products.

To misquote Bill Clinton, ‘It’s the balance sheet, stupid’.  It is the regulatory and mainly capital rule changes that have altered the provision of interest-rate risk transfer mechanisms available today. The current construct remains likely incomplete and certainly untested in terms of scale by the market’s users.

As such, ETD and OTC will need to co-exist.  New instrument types, such as swap futures, whilst unproven, underdeveloped and new, are nonetheless an essential missing link in the IR markets of today.

Advanced new asset management operators offering LDI services who provide flexible and transparent products and services that see the world as one linked continuum of IR risk, both ETD and OTC, are likely to thrive.  They will probably win pension fund de-risking mandates, which tend to be the most discerning selector of appropriate IR risk management products and, through necessity, pioneering users in interest-rate risk transfer mechanisms.

There is a pressing need for active, old and new market participants of all types to be willing to step in and provide the traditional risk-transfer function of markets, with a steady eye on their business models.  Also, a new generation of LDI products, including some form of alpha generation, needs to be urgently designed and adopted, given real yields’ flirtation with negative territory. 

In addition, for those asset managers that call the market structure moves correctly, there is a significant business opportunity to win new market share and an ability to avoid significant unnecessary costs.

‘The best way to call the market structure correctly is to take a view and influence outcomes by being proactive,” says Ricky Maloney, of the rates and LDI team at Old Mutual Global Investors.

This is something relatively unknown in the asset management sector, because it has historically been the banks that have driven such market innovations and change.  

Given what lies ahead, what should an asset manager do? 

• Spend time on market structure;
• Explore and understand new products like swap futures;
• Talk directly to product providers and innovators;
• Start to plan and budget for market infrastructure change;
• Seek information from bank and non-bank sources and 
• Compare the pictures and data provided.   

Crucially, asset managers need to hold views on market structure topics and express them vocally, as well as getting into the business of sponsoring and founding new markets.  Welcome to the world of ‘picking winners,’ perhaps the other ‘missing’ ingredient on the journey to the brave new world of interest rate risk-transfer markets.