Counterparty risk is defined by the UK’s Financial Services Authority (FSA) as the risk that a counterparty to a transaction could default before the final settlement of the transaction’s cash flows. An economic loss would occur if the transaction or portfolio of transactions with the counterparty has a positive economic value at the time of the default.
Looking at the example of a homeowner hiring a contractor, it is considered good practice to obtain references and otherwise complete due diligence as a natural part of the decision making process, to reduce the chance of default risk by the contractor. However when we approach a large bank often this step might not be considered necessary, as we may trust that this entity adheres to regulatory requirements which are designed to ensure the stability of such institutions. As there is no real-time way to monitor the balance sheets of key counterparties, hedge fund managers are often left with finding other alternatives to protect themselves from the fallout when one of their financial counterparties has a meltdown or otherwise does not live up to its contractual obligations.
Learning from Failure
Counterparty risk is a challenge faced by all players in the financial industry. Pre-2008, banks believed that hedge funds were one of the greatest sources of counterparty risk. However, in 2008 when Bear Sterns was rescued by JP Morgan and then Lehman Brothers Holdings Corp (‘Lehman’s’) collapsed, it became clear that the risk could be reversed, and banks have the potential to pose a major risk to hedge funds. When Lehman’s folded in September 2008, many funds were frozen with trades they couldn’t close and therefore resorted to invoking side pocket and gate provisions in order to manage liquidity. In the four years since then, managing counterparty risk has become a critical component of hedge fund operations.
Lehman’s was not necessarily an isolated case; demonstrated by the recent downfall of US brokerage firm MF Global in late 2011, which has been attributed to exposure to Eurozone debt, as well as the common industry practice of re-hypothecation. Hypothecation is the use of collateral to back a debt, and brokers often use collateral which has been deposited by clients to back their own proprietary trades and borrowings (re-hypothecation), a practice which is perfectly legal in the US and UK. According to an article by leading US law firm Crow & Associates, legislation in these jurisdictions also appears to allow this collateral to be re-hypothecated more than once, and often brokers end up re-hypothecating assets several times, known as ‘churning’ .
In the MF Global case, an estimated $1.2billion in customer funds disappeared, and the firm’s CEO Jon Corzine testified that he did not know what happened to these funds. Speculators have suggested that the fact that MF Global used re-hypothecated collateral to invest in repurchase agreements in large sums of Eurozone debt resulted in this loss of funds. Hedge funds once again took a hit when this happened, despite the major efforts by global governments to control the risks taken by financial institutions. As a consequence, whether it’s a Wall Street investment bank, or a Canary Wharf prime broker, alternative asset managers need to limit their counterparty risk effectively.
Worldwide, governments are currently attempting to address the systemic risk posed within financial markets. There have been calls for the separation of investment and commercial banking, after the Glass-Steagall Act was repealed in 1999. (Glass-Steagall was enacted in 1933 as a reaction to the Great Depression in the 1930s.) There are arguments which suggest that the risks taken in securities lending should be completely separated from commercial bank customers’ funds. US law currently requires a financial institution to limit its exposure to a single entity to less than 25%. However as the US ushers in regulation to prevent another financial crisis through the Dodd-Frank act, the Federal Reserve now proposes that large, important institutions limit their exposure to single entities to 10%.
The FSA in the UK has also recently issued guidelines including frameworks and procedures to mitigate counterparty risk which apply to smaller financial entities as well as large institutions. Specifically, these guidelines are aimed at central counterparties (an entity that interposes itself between the two counterparties to a transaction, becoming the buyer to every seller and the seller to every buyer i.e. prime brokers). For fund managers, it is important to understand if their prime brokers adhere to these, or similar, guidelines.
In Europe, a legislative proposal has also been submitted by the European Commission on derivative transactions and central counterparties (CCPs). The European Market Infrastructure Regulation (EMIR) states that ‘a CCP’s main purpose is to manage the risk that could arise if one counterparty is not able to make the required payments when they are due i.e. defaults on the deal’. EMIR’s proposed legislation aims to render the OTC derivatives market more transparent in order to facilitate credit and operational risk management. The proposal states that there will be thresholds which will exempt some CCPs from the legislation but details are yet to be released.
Additionally, the Committee on Payment and Settlement Systems and Technical Committee of the International Organisation of Securities Commissions (CPSS-IOSCO) issued a report in early June 2012 which outlines high international standards for derivatives market intermediaries. These standards relate to prime brokers, enabling them to manage counterparty risk, limit the risk of fraudulent behaviour, and mitigate systemic risk in the OTC derivatives market.
Implications for Fund Managers
The monitoring of counterparty risk is an on-going process with a growing field of service providers offering various solutions, and choosing the right broker and service providers are key steps to managing risk exposure. Best practices for proactively managing counterparty risk include ensuring robust internal procedures relating to portfolio and risk assessment, formalizing outsourcing procedures and the use of portfolio management systems, separating banking services from the brokerage relationship and using a recognised and regulated third party which is independent from the financial counterparty for the fund’s administration. In much the same way that independent directors provide confidence and oversight of the fund, an arm’s length third party administrator can help to ensure the accuracy of reporting for the manager by offering independent daily trade reconciliation, monitoring and review of the processes during the period,
as well as independent calculation of the fund’s Net Asset Value (NAV), thus reducing risk and increasing shareholder comfort and confidence.
The fact that institutional investors now dominate the hedge fund market means that investor demands are becoming increasingly sophisticated. This is a global trend seen in developed nations as well as emerging economy regions such as Latin America and the Middle East. The various media reports on the risk of fraud as a result of lack of financial transparency have urged investors to look for information on where assets are held, thus the fund manager needs to be able to provide clear information on the fund’s custodian, sub-custodian, brokers and bankers. The agreements with these counterparties will outline this information, as well as procedures in the event of a credit default and therefore should be scrutinised carefully before such contracts are executed.
When choosing a custodian or a prime broker, it is extremely helpful to take advantage of an experienced industry service provider who can assist with introductions to the relevant providers, as well as provide input with regard to which providers are strong in a particular area or in relation to a particular investment strategy. Third party independent administrators with no ties to a financial institution can assist in this regard. They will have experience with a wide array of global financial firms, and are generally happy to work with any institution that a client brings to the table. Equally, they can provide introductions to a choice of industry service providers with whom they work on an on-going basis. Likewise introductions/references from industry peers can be very useful and should be utilised.
Employing more than one broker and banker is an effective way to diversify and minimize exposure to any one institution; however one’s fund size may limit one’s ability to undertake multiple relationships and with fewer creditworthy institutions to choose from, the overall risk remains an issue. If a manager’s fund is large enough, they can use such a multi-prime model, contracting more than one prime broker, although they must be aware that this will increase the complexity of the middle and back office operations of a fund. In order to help manage this complexity efficiently, a third party fund administrator can provide a high level of experience, automated processes and coordination of the disparate data repositories. This is provided while helping to monitor exposures from a risk management perspective and ensuring cost efficient service, as well as accurate real-time reporting.
One operational mechanism which can be used to protect a fund manager’s assets is the use of segregated accounts. Subject to size the of Assets under Management etc, the manager may be in a position to negotiate terms whereby the fund’s assets are held in accounts which are segregated from the general assets of the relevant institution and thus not available for re-hypothecation. An alternative, but related tactic that fund managers have been using to manage counterparty risk in a prime broker is the use of ‘amber terms’. These terms state that if a broker’s credit default swap (CDS) spread goes beyond a certain point, the unaffected assets are moved to a separate account as a precaution. Amber terms should be written into a prime broker agreement, and a fund manager can formulate the terms by carrying out due diligence on a prime broker and evaluating its exposure to various markets, industries and regions.
In a world where counterparty risk is widespread and seemingly, increasing by the day, fund managers have some options available in order to limit counterparty risk. These include diversification of counterparties
(where possible), industry referrals and references, service provider due diligence and defined risk avoidance procedures.
There is no panacea from counterparty risk in today’s world. A recent example is the story of PFG Best, the US futures broker which was revealed to be holding $5million in a bank account which it had stated held $225million. This missing $200million was concealed, whereby the broker forged documents which it sent to the National Futures Association. PFG Best holds less than a tenth in assets of what MF Global held but it serves as reinforcement that counterparty risk continues to be an issue. What serves as an even greater warning was when credit ratings agency Moody’s downgraded 15 of the world largest banks in June. Moody’s has effectively downgraded the credit worthiness of the entire financial industry, highlighting the risky times we live in. The old approach of ‘banks are safe as houses’ is no longer acceptable and duly diligent monitoring of all relevant counterparties is unfortunately a sign of the times and an issue that all fund managers need to address.
The benefits of automated pension plans
While many people will prefer to speak to fellow human beings when discussing their investments, automation is already part of everyday life. Over the last few years we have seen introduction of robo-advisors, with many pension investment companies placing these new platforms front and centre of their future strategies. So, what are the benefits of automated pension plans and robo-advisors?
No-nonsense information gathering
KYC, or Know Your Client, is an integral part of the investment world. The wider your knowledge base on a particular client the more personalised the service you can offer. Failure to gather the correct information, and use it accordingly, is a breach of investment regulations in many countries. Therefore, the use of robo-advisors allows a no-nonsense and clear approach to information gathering.
These systems use an algorithm to choose the most appropriate investment strategy for your pension fund. The algorithm is based upon issues such as:-
- Your attitude to risk
- Your investment term
- Your current investment goals
It is worth noting the variable “your current investment goals”. Due to the way that the system is set up, you can update your investment goals on a regular basis. This means that your portfolio would be automatically adapted to your new goals.
As pension-fund regulations continue to be tightened, information gathering is becoming even more important. This initial data gathering exercise will also incorporate a degree of guidance and thought provoking comments. For example, this could highlight the risk/return ratio and the suitability for pension fund investment. The concept of the robo-advisors platform is simple; participants have time to think about the consequences of their attitude to risk for example. The majority of platforms use a concept known as modern portfolio theory.
What is modern portfolio theory?
As a sidenote, you will find that many robo-advisor platforms will mention the concept of modern portfolio theory. This is a Nobel Prize winning economic theory based on the use of data points to create a personalised portfolio of investments. Modern portfolio theory presumes that the majority of investors are risk averse. This means that those looking to take additional risk will expect additional rewards. As a consequence, their pension-fund portfolio would need to reflect this.
Using ETFs to create a personalised portfolio
Automated pension investment platforms (also known as robo investing) tend to use Exchange Traded Funds (ETFs) to create personalised investment portfolios. ETFs have been around for many years and they are an integral part of the investment scene. There are numerous benefits to using ETFs such as:-
Focus on a particular market/type of investment
ETFs are basically funds which are structured to mirror the make-up of a particular market, sector or type of investment such as a commodity or index. For example, the S&P/TSX Composite Index is recognised as the benchmark Canadian index. As a consequence, for those pension fund investors looking at a balanced risk/return, an ETF mirroring this index would be ideal for their portfolio. The funds are created by replicating components/weightings of a particular index with some ETFs also using futures and options
Just as indices are rebalanced from time to time, it is important that your pension fund investments undertake the same process. Say for example the robo-advisor system created a personalised portfolio consisting of two index ETFs. If one index was to perform much better than the other, at some point this would need to be reweighted. The strategy behind this is simple; if the balance of your portfolio was tilted towards one particular ETF index then your future performance would also be tilted towards that index. This could lead to increased volatility and impact the balanced approach to investment.
Price visibility and trading
While many people view ETFs and mutual index tracking funds as one and the same, there are a number of differences. The main difference is liquidity, with ETFs constantly traded throughout the day and mutual fund prices set at the end of each trading day. As a consequence, robo-advisors can react to intra-day news flow, while those holding mutual funds will need to wait until the daily price has been set. You’ll often find that transaction costs associated with ETFs can be significantly less than mutual funds.
Risk profile criteria set by human experts
While the majority of the processes associated with automated pension plans have little or no human input, there is significant input with regard to risk profiles. This means that investment experts will allocate particular ETFs, and other exchange traded instruments such as futures, to various risk/reward profiles. When we talk of risk/reward in the context of pension investments, this does not indicate extreme risk – this isn’t advisable for long-term pension investments. Indeed, those pension advisors allocating funds to ETFs offering extreme risk/reward ratios may find themselves answering questions from the regulators.
In the modern era, there is nothing to stop the process of opening a pension fund, right through to management of investments, from being fully automated. Whether we move closer to this alignment in the future remains to be seen. However, in the meantime the vast majority of investors prefer an element of human expert involvement, even if just to oversee any potential discrepancies.
Low-costs improve long-term returns
The cost of any service or product comes down to the components. Traditional active pension fund investment will involve an array of different people with different skill sets. The combined cost of these teams can be significant and is reflected in the fund’s management and ongoing charges. Therefore, the more elements of the system which can be automated the lower the management fees and ongoing charges. When you also consider that many robo-advisors will use ETFs, which simply track various assets or indices, the cost element is yet another competitive edge.
While there is certainly a place for active investment management, using expert investment advisors, very often automated pension plans will complement this alternative approach. Many people now choose to maintain a core element of their pension fund under a robo-advisor platform, as their pension-fund backbone. Allocating an element to a more active investment approach offers the opportunity to enhance returns, although there is an obvious element of risk.
Easy-to-use investment platforms
The subject of pension investment can be complicated at the best of times. Therefore, the introduction of robo-advisor platforms, offering regulatory updates and guidance, has been extremely useful for many people. A growing number of people seem to prefer this plain talking approach to pension fund investment. You could argue that this removes any potential conflict-of-interest, the volatility of human nature making way for cold hard facts. Obviously, there will be advice and guidance available, as and when required, but this would likely come at an additional cost.
It is worth noting that before any robo-advisors platform is released to the market it will undergo stringent testing. This testing will take in both in-person testing and remote user testing which is unmoderated. As a consequence, those creating these platforms can help and assist those testing the systems in person. On the flipside, remote user testing is akin to releasing the platform into the mass market. These users are guided by the instructions and design of the platforms, giving invaluable feedback on any tweaks and changes required.
Removing human emotion
The removal of human emotion from investment decisions can be considered something of a double-edged sword. However, robo-advisors provide a no nonsense approach to pension fund investment. A relatively swift in-depth questionnaire will gather all of the information required, allowing algorithms to calculate the appropriate risk/reward ratio. The use of EFTs takes away day-to-day management of investments, in favour of index tracking funds. Auto rebalancing and opportunities to adjust your risk/reward ratio going forward creates a very flexible environment.
Those looking for a passive investment strategy will be attracted to robo-advisors. Those looking for a more active approach still have plenty of choice in the wider market. Then there are those looking for a mix of the two. In recent years we have seen huge advances in artificial intelligence, which already play a role in wider investment trading strategies. Will this technology become more commonplace in the future?
Robo-advisors have been around, in some shape or form, for some time. In many ways they do the time-consuming legwork that human advisors did in the past. This allows pension advice companies to focus their funding on areas where they can enhance their business. There is a general misconception that robo-advisors have total control over pension fund investments. This is wrong. There are human advisors and investment experts in the background tweaking the system, allocating EFTs to specific risk profiles and constantly enhancing their offering.
While the current raft of robo-advisors make little or no use of artificial intelligence, the ability to learn, this must surely be an aspiration for the future. This is an area of the market which is constantly developing and changing. We already accept artificial intelligence in many areas of our life, so why not the world of investment? Would you trust an advisor who was able to learn from human mistakes?
This is a Sponsored Feature.
The Viral Return On Investment
By Sabine Saadeh Author of Trading Love
It was around August 2018 when a friend of mine approached me with an investment scheme that was remarkably enticing. At first I hesitated because going into business with close friends is never a good idea for me, let alone have your money pooled into an investment fund. The business model was exceptionally thought through and I knew for a fact that it will generate value. Nonetheless, I declined the investment offer. A year later, the fund was generating income long before it had planned to, and I thought I had missed out. The return on investment from that fund in relation to the cost of the investment was outstanding.
A year later, I watched from afar as my friends began to squeeze each other out given their greedy excitement after the success of their fund. As more time went by, I watched them make the biggest mistake of their lives, and that was letting go of the creative element in that fund. Return on investment is the value created by the said investment that is closely tied to economic, financial, psychological and societal factors. However, creativity is their cornerstone.
Come 2020 and Covid-19 reshuffled the classic value mantras. The whole world experienced complete disruption. The path of the virus and the length of time the global economy will remain shuttered is still very much unknown. So what does this mean? This means that investment value will change. The risk of the investment does not have to do anymore with the amount of capital available for resiliency but with the amount of creativity available in the business.
The viral return on investment should change people’s economic narrative. Businesses should focus on liquidity, contingency plans, multiple supply chains and CREATIVITY. After all a business’ local resilience will be highly priced in the value of the investment rather than what the market views as efficient. Taking my friends’ fund as an example, if they had retained their creative element, their business would have proved to be resilient, despite the high debt incurred by the fund to continue operating during lockdown. This high debt increased the risk of their business collapsing and in turn weighed in on their capacity for growth.
After all, an investor is looking for an investment that will preserve his/her purchasing power without undermining their wealth. If I had invested in that fund, I would have lost the capital invested and spent the income generated during the lockdown period. So what was the point of the capital without the talent in that fund? Covid-19 is not the only threat; climate change is even a bigger threat. It is therefore imperative for us to respect and nourish interdependence, and especially in business environments.
We cannot act like the virus anymore, latch on to a person with creativity and sup them dry just because we invested in them. We need the creative more than the creative needs us, it is their talent that is going to generate income for us. Our capital opens the path for the creative to generate income for us. The smart people of the world already set their bets on that, through ESG investment schemes, which is the most sustainable form of investing. ESG which means environmental, social and governance investing; seeks positive return on investment while taking into consideration the long-term impact of the said investment on society, environment and the performance of the business.
The year 2020, is when the world went up in flames and ESG established itself as the mainstream way for investors to make profits. Although the investment preference had already began to change over the last five years, the inflow was still very mediocre in ESG.
It was after the wildfires and the social issues erupting everywhere in the world and the corruption stories of the businesses that are too big to fail, that it became a no brainer that the inflow in ESG would increase massively. Then The DWS Group’s ESG funds according to CNBC began to outpace the S&P 500 this year, and Blackrock highlighted ESG as the most sustainable form of investing.
Businesses that are taking into consideration empathy and creativity while operating are better equipped for future sustainability, even though they are sacrificing return on investment in this present time.
What are we waiting for then? If Covid-19 didn’t help us see clearly that we all intertwined in nature for our future’s sustainability, then what will?
European market responds to second wave of infections
By Rupert Thompson, Chief Investment Officer at Kingswood
Global equities ended last week on a negative note and were down around 4.5% from their all-time high in early September. This morning, European markets have fallen back a further 3%.
The initial catalyst for the correction was a sharp run-up in the mega cap tech names which had left them looking extended and ripe for some profit taking. The FAANGs are now down over 10% from their highs and the froth looks like it has been blown off. While they may well remain volatile, there is no obvious reason for them to be at the forefront of any further sell-off. The fundamentals behind the tech sector remain strong and valuations are once again looking more reasonable.
However, the correction also clearly had its roots in the sheer scale of the rebound from March with global equities up some 50% from their low. This inevitably left markets vulnerable to a set-back, particularly with valuations at twenty-year highs.
The rebound in turn was in good part a result of the massive policy stimulus. The weakness late last week was triggered by disappointment that the US Fed had not extended its QE program. Even so, the Fed is still buying $120bn of bonds a month and remains a major support for equities. Indeed, it made it clear that it has no intention of raising rates for at least another three years.
The Bank of England also decided to leave policy unchanged last week. However, it kept open the possibility of cutting rates into negative territory next year if it should be necessary. An extension of its QE program later this year also remains quite possible.
All the same, the fact of the matter is that central banks have now spent most of their ammunition. Going forward, changes to fiscal policy will be much more important than any tweaks to monetary policy in shaping the economic recovery. And on this front, the news is not particularly encouraging as the markets may now be appreciating.
The US has failed to agree on an extension of the fiscal stimulus measures which expired in July and may now not be able to before the November elections. As for the UK, Rishi Sunak is still resisting calls to extend the furlough scheme beyond October.
Just as important for markets will of course be Covid-related developments. This morning’s declines are a response to the second wave of infections now being seen in the UK and across much of Europe and fears that renewed social distancing measures/localised lockdowns could disrupt the economic recovery.
While the latest wave of infections is clearly a major cause for concern near term, it shouldn’t be forgotten that the longer term outlook regarding Covid is not all bad. Several late stage vaccine trials are now underway and a vaccine could quite possibly become available within a few months. Some countries, most notably China, also seem to have avoided a major secondary spike despite the reopening of their economies.
In short, the outlook remains quite uncertain. We believe it remains prudent at this juncture to maintain a broadly neutral stance on equities until some of these unknowns are cleared up – one way or another.
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