Approximately $626 trillion in notional credit and currency derivatives are outstanding, a majority likely traded OTC. Last week (March 11) all OTC IRS and CDS swaps had to be centrally cleared via approved centralized clearing mechanisms (ICElink, CMEclear, etc..). Centrally clearing these products now involves posting margin (initial average calculations at 150 bps) of notional value in addition to collateral posted to CCPs.
This money on the sidelines will deleverage a number of non-equity players in the Private Fund industry as well as hit performance. It will be interesting to see the “true” incremental margin rates as OTC clearing it still in a flux as the June 10 deadline for Private Fund central clearing of OTC IRS and CDS swaps approaches.
As this WSJ articles states, the SEC new presence exams can dig deep into a Private Fund’s operations. The potential exists for the SEC to review a fund’s Ledger and request receipts across a variety of fund expenses.
A key point is that funds have a “fiduciary” duty to act in the best interest of clients, including policies and procedures to allocate expenses fairly to the client. Given these Presence Exam policies, firms need to:
1) Develop expense allocation policies and procedures (including thresholds for travel, entertainment, and other non-operating expense categories)
2) Disclose to existing investors (by updating and circulating as part of the annual policy/procedure update or distribution of the fund audit
3) Disclose to potential investors (as part of DDQ and/or separate policy/procedure room in due diligence review)
Increasing operational costs and compliance requirements are impacting the cost of running a fund. For established funds, this increase has created the need to add support office functions (back-office, reporting, and compliance resources). For new funds, the high cost, creates a barrier to entry (at a maximum) and a higher start-up baseline investment in support functions (at a minimum).
Let’s look at a few of the cost drivers:
1) Need for increased transparency – Clearly, a positive benefit for anyone running and/or investing in a fund. However, this benefit comes at a cost. Funds have invested in risk, performance management, and reporting systems.
2) Regulatory requirements – Form PF, FATCA, and registration with governing agencies have underlying operational and reporting costs.
3) OTC Swap Clearing – Additional capital/collateral requirements to clear a swap transaction via a CCP require additional borrowing and/or capital to be held in a “minimally productive” account.
Higher costs and Barriers To Entry create incumbency. In a complex world that requires continual evolution, incumbency can lead to lower macro returns and less choice for investors.
Today’s announcement of a deposit levy in Cyprus crosses a Red Line in liquidity assistance for the banking sector. The first question: Is it legal? Can a government seize private assets to pay for mistakes of the custodial bank? Unfortunately, that is a theoretical question which is most likely going to be swept under the rug as time is the real driver here. In other words, now that the Cyprus government has started the bank run, there is no turning back. Bank customers will either have to accept the 7 – 10% penalty as opposed to a full-scale banking collapse.
The longer term issues are more pertinent. Depositor and Investors will not forget the Red Line being crossed here. For smaller emerging market central banks, this likely makes future bank runs more likely as investors will be wary now that the red line is crossed In addition, investors will require higher yield and more stringent capitalization requirements.
Again, the lessons from overall financial collapse:
1. Don’t be first….Don’t be last.
2. Be Too Big To Fail
3. If you are small, have big friends (Would Cyprus be allowed to seize assets if large banks and/or US had a large presence in Cyprus)?