Investment Managers would like to use a wider range of derivatives in increasing volumes, but the majority are being held back by operational limitations, according to a new survey by Morse, the international consulting company, in conjunction with Global Investor magazine.
Morse interviewed 50 investment managers, including hedge funds, for the survey, which focused on OTC derivatives strategy and operations.
Twenty-eight percent of respondents said they were planning to offer credit/high yield arbitrage strategies in the future, highlighting the desire to expand into derivatives-focused areas.
Chris Sier, consultant at Morse, says, “There are a number of drivers behind the appetite of investment managers to increase the range and volume of derivatives they use. This includes enabling legislation such as UCITS III, which allows managers to add derivatives to funds to create alpha, but also demand from customers for tailored products.
“However, although the legislation is in place and appetite from both Investment managers and customers is there, use of derivatives is not increasing as quickly as many would expect and as investment managers would desire. This is due to the operational limitations of managing and processing derivatives.”
Fifty-eight percent of respondents to the Morse/Global Investor survey said they used multiple sources for valuing their OTC derivatives portfolios, and a staggering 42 percent used three or more sources.
Though 40 percent said they only used one source, the source used varied widely across different Investment Managers, with no one preferred source. The most popular valuation sources were specialist providers and internal spreadsheets but other methods included counterparties, internal specialist systems and hedge fund administrators.
“This survey highlights that there is no single source which all investment managers feel they can use to value their OTC derivative portfolios,” Chris Sier continues. “Building an operating model to manage derivatives is not easy because of the complexity of the task. As a result, almost 60 percent are forced to adopt a blended or mosaic’ model involving a combination of some, or all available methods. Worryingly, 5 percent of respondents use five or more sources which could be a potential operational nightmare to manage. Over and above valuations, the complexities of lifecycle management, confirmations, reconciliations, etcetera, add to the problem.
“Outsourcing to a one-stop-shop might appear the obvious solution, but there is currently no custodian supplier that has the entire capability to offer this. These capabilities comprise both product scope, which is the ability to manage all types of derivatives from the most vanilla to the most exotic, and the service scope, which is the ability to manage the full range of derivates related process, from transaction processing through to pricing and risk reporting.”
Respondents to the Morse/Global Investor survey were asked what the main reasons were why their company has not outsourced any OTC derivatives operations at this stage. Forty-five percent said the lack of availability of suitable providers and a further 55 percent said a lack of business or financial benefits.
“These results highlight the inability of outsourcers to provide a suitable level of service for OTC derivatives at an attractive price,” Chris Sier says. “Full capability can be found in prime brokers, boutique hedge fund administrators and investment banks, but these all have their drawbacks. Prime brokers are very expensive when used at scale, hedge fund administrators lack scale and perhaps credibility in the institutional market and investment banks have yet to decide whether they wish to enter the market.”
Chris Sier explains that this provides a great opportunity for the outsourcer who can be first to the market with a suitable, comprehensive and cost effective method of managing derivatives.
“There is a potentially huge market for an outsourcer who can develop the necessary systems to cope with Investment Manager demand for derivatives,” he says. “Such capability could also be used as a loss leader to win wider mandates, such as full Fund Administration or Custody contracts. Many outsourcing providers are currently working on this and we expect a credible provider will not be long to emerge.”