Research by Sapient Global Markets into how new central clearing mandates will impact investment performance for buy-side firms has revealed a significant drag on portfolio returns in the new regulatory environment.
The drop in return ranges from between −0.20 per cent to −0.62 per cent for cleared hedges, up to almost 1.00 per cent for traditional uncleared bilateral over-the-counter (OTC) trades.
The Sapient Global Markets “Cost of Clearing: A Buy-Side Investigation” study quantifies and compares the costs of a typical buy-side portfolio hedging strategy in terms of drag on portfolio returns. The study compares the overall portfolio performance of a typical fixed-income fund using four different hedging instruments over a fixed historical period: uncleared swaps subject to pre-2008 margin requirements; uncleared swaps subject to the Basel Committee on Banking Supervision (BCBS) and International Organisation of Securities Commissions (IOSCO) guidelines for margining (effective after 2015); swaps cleared through LCH.Clearnet SwapClear; and Eris Standard swap-futures (cleared through CME).
“Because of the significant impact on performance these results demonstrate, as well as the June 10th timeline set by regulators, it is apparent that portfolio managers must examine their own hedging strategy based on expected cost of clearing with a renewed urgency,” says Ben Larah, manager, Sapient Global Markets, “Once the post-Dodd-Frank and BCBS/IOSCO recommended treatment for uncleared derivatives takes effect, using standardised and centrally cleared instruments will be the cheapest available option.”
On 11 March 2013, firms categorised as swap dealers, major swap participants and active funds were required to centrally clear several types of interest rate swaps — across four currencies — and certain credit default swap index trades. On 10 June 10 2013, “Category 2 Entities,” including securitisation vehicles, insurers, investment funds and non-swap dealer financial institutions must begin mandatory clearing. In order to comply with complying with regulations, firms need to make informed decisions about how to invest and where to clear.
“Recent regulations mandating central clearing of OTC derivatives creates performance challenges for all investment firms and their bank counterparties alike,” says Kevin Samborn, vice president, Sapient Global Markets. “Sapient Global Markets’ experience in developing diverse OTC clearing and collateral solutions help firms effectively address these latest challenges while at the same time help to evaluate the cost of central clearing on their current strategy and develop solutions to retain maximum returns moving forward.”
The results of the study show that cumulative portfolio returns are highest when hedging is performed using uncleared swaps in a pre-2008 environment, and lowest when hedging is performed using uncleared swaps in a BCBS/IOSCO recommended environment. These results serve to show the significance of the impact of Dodd-Frank/BCBS legislation on clearing costs; once the BCBS/IOSCO recommendations take effect the use of customised, uncleared swaps will jump from being the cheapest way to the most expensive way to hedge.
Sapient Global Markets conducted this study with support from LCH Clearnet and Eris Exchange.