DERIVATIVES GOVERNANCE: enabling product innovation for asset managers

  • 73

    DERIVATIVES GOVERNANCE: enabling product innovation for asset managers

    Derivatives are becoming a valuable tool for asset managers to boost product innovation and deliver outperformance in a risk-controlled manner. But current, reactive governance structures are creating a long lead time for assessing and approving a new derivative instrument. Geoff Cole and Jackie Colella explain how strengthening governance, approval and operational due diligence can help investment managers reduce time to market and more quickly respond to portfolio managers’ needs.

    Typically considered an instrument reserved for hedge funds and complex investment strategies, derivatives are becoming far more common 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 downward pressure on both 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 to not only 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 derivatives as an asset class alongside equity and fixed income. Having a more complete range of derivative capabilities 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 ability to better understand and govern derivatives usage has enabled investment management firms to not only execute derivatives at a lower cost but 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.

    THE CHALLENGE FOR ASSET MANAGERS
    The complexities of derivatives and firms’ disparate individual abilities to implement and manage the operational risk associated with introducing new derivative 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
    4. 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 multiasset/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. 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.

    Firms should consider implementing a dedicated, fully resourced derivatives team with appropriate product knowledge and capacity levels to support the onboarding lifecycle. In addition, reviews should be conducted on a regular basis. The majority of firms review derivative usage bi-weekly or once a month, yet almost all said their committee convenes on an 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 resourced in staffing for onboarding new derivative instruments.

    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 Sapient spoke to stated that their governance structure is far from streamlined and that challenges and backlogs exist primarily in operations and technology.

    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.

    Derivatives Governance Figure 1

    Figure 1: Finding the Right Balance. As product innovation accelerates and competition for assets increases, derivatives usage will continue to grow in both volume and complexity. To position for long-term growth, investment management firms must reach a greater level of maturity with respect to the governance model, so they can support the increased usage of derivatives instrument types as part of existing and new product offerings.

    Legal Agreements
    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.

    When Sapient Global Markets asked asset managers about legal 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 and Constraints
    The amplification of new regulatory requirements for trading and clearing of derivatives has created greater challenges with firms’ legal review and documentation processes. The new regulatory requirements have changed the legal review and documentation process in the following 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 to review regulatory changes
    • Most changes occur only in the documentation
    • Because the regulatory environment may change, the process is largely “case by case” in which firms may “inform” rather than “request” approval from the client
    • Regulatory mandates in Europe are especially challenging for derivatives

    Balancing Time to Market with Operational Risk
    In Sapient Global Markets’ interviews, asset managers stated that it can take anywhere from three weeks to one year to completely onboard a new derivative instrument type. The majority of firms also said 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 for over a year and will sometimes lead to the decision not to make the instrument type available to portfolio managers at all.

    In addition, the majority of firms said they complete a full end-to-end testing of any new derivative instrument. However, in some cases, this testing is completed for one specific business unit rather than firm-wide, which can increase operational and business risk in the trade lifecycle if another business unit subsequently attempts to trade that 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.

    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 timeto-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.

    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.

    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. For example, asset managers are encouraged to consider a number of factors, such as determining if using Special Investment Vehicles (SIVs) across accounts is a viable option, preparing for BCBS 269 compliance and other regulatory change, and providing all personnel with appropriate derivatives education and training.

    TURNING CHALLENGES INTO OPPORTUNITIES
    As product innovation accelerates and competition for assets increases, derivative 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 toward front-to-back trade flow improvements.

    In order to support increased usage of derivatives, most firms need to refresh their governance, approval and operational due diligence process. Yet the majority of the investment managers interviewed have reactive governance structures, which is a major contributor to the time lag of assessing and approving a new derivative instrument. In addition, no investment manager was continuously improving their governance structures, suggesting that derivatives governance is not 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 organizational growth in accordance with derivative 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.

    The Authors
    Geoff Cole

    Geoff Cole
    is a Director of Business Consulting with Sapient Global Markets’
    Investment Management practice based out of New York. Geoff focuses
    on supporting investment managers with business, data and technology
    strategy. Most recently, Geoff has led projects helping global asset
    managers design operating models to support broader derivatives usage
    as well as select and implement solutions for performance attribution and risk analytics.

    Jackie Colella

    Jackie Colella
    is a Senior Manager of Business Consulting. Based in Boston, Jackie plays a leadership role in helping Sapient Global Markets’ clients drive innovative strategies to improve business performance and manage risk. Jackie is a primary interface for our clients, structuring and planning engagements, implementing critical delivery teams and developing relationships.

    Leave a Comment