Derivatives users slow to learn crisis lessons

Most end-users of derivatives lack the ability to manage their risk properly, according to a recent survey by BNY Mellon. We talked to them about best practices.
Patrick Tadie, BNY Mellon
Patrick Tadie, BNY Mellon

If proof were needed that history is doomed to repeat itself, it came recently in the form of a study into how end-users manage the derivatives they buy. After the collapse of three of the market’s biggest counterparties — Bear Stearns, Lehman Brothers and AIG — most people might expect that the buy-side has wised up. Once bitten, twice shy, right?

Wrong, apparently. When BNY Mellon asked a group of clients recently if they had the capability to price the over-the-counter derivatives contracts they had entered into, just 40% said yes. Without that ability, most have to rely on counterparties to value their collateral for them. “That’s a really bad thing to do,” according to Patrick Tadie, global business head of BNY Mellon’s Derivative360 unit, who was in Hong Kong yesterday to present the findings of the study to clients.

Tadie’s Hong Kong-based colleague, Andrew Gordon, executive vice-president for broker-dealer and alternative investment services, recounted a conversation he had in November 2008 with a Chinese bank client who had wondered why Lehman never called to return collateral to them. “Not only were they not valuing their positions, but they weren’t proactively calling the mark when money was owed to them by Lehman Brothers,” he said. “They weren’t calculating that, identifying that there was an amount due, making the call, receiving it or reconciling it. All of that takes effort and investment.”

Since the crisis, industry efforts to come up with best-practice guidelines have tended to focus on banks and broker-dealers, rather than on buy-side institutions. It might be tempting to think that over-the-counter derivatives have become less popular during the past three years and that their use is less of an issue today, but that is far from the truth. The over-the-counter derivatives market is just as big today as it was back then. In June 2008, the outstanding book of business in the over-the-counter market was $550 trillion. In December 2010, it was $570 trillion.

Despite the crisis, the over-the-counter market is not going to disappear any time soon. More than 80% of the respondents to BNY Mellon’s survey said their usage of such contracts was either stable or growing.

All the more important, then, that end-users properly manage these derivatives positions. “You really need to know what their value is on a daily basis because, if not, you’re either posting way too much collateral or you’re taking risk with counterparties that might not be around tomorrow,” said Tadie. “As the events of 2007 and 2008 pointed out, it’s probably a really good idea to know who your counterparties are, how much exposure you have out to them and what can be done if there’s a problem with one of them.”

BNY Mellon’s white paper, titled Mitigating Collateral Damage and co-authored with InteDelta, surveyed 24 asset managers, insurers and pension funds, including, for example, Franklin Templeton, Aviva Investors and the Florida State Board of Administration.

The report also showed that 90% of respondents continue to use mark-to-market valuations with no forward-looking capability, instead of potential future exposure calculations, which the industry considers best practice.

Firms such as BNY Mellon, Citi, HSBC and J.P. Morgan offer services that allow end-users to outsource their collateral management. BNY Mellon formed its Derivatives 360 business last summer and has so far set up dedicated teams in New York, Pitsburgh and Frankfurt, with plans to build teams in Hong Kong and Singapore as well.

The business is multifaceted but it primarily focuses on anything in a client’s front, middle or back office that has to do with derivatives transactions. BNY Mellon acts as a counterparty and, thanks to its triple-A rating (it is the only top-rated financial institution left in the US), provides a good level of confidence. The team also manages collateral, reconciles derivatives portfolios on a daily basis, offers valuation services, trade confirmation and lifecycle management, among other things.

All this comes at a cost, of course, so many end-users continue to make do with using standard spreadsheet software to manage their derivatives positions. Part of the problem is the endless search for new and exciting products to sell to clients. After all, putting the trades on is easy enough for the front office to do. “Usually what ends up happening is that they can enter into the transactions, but their middle and back office can’t handle them,” said Tadie.

The good news is that service providers are gearing up to handle those processes on clients’ behalf. On the cost front, BNY Mellon stresses that farming the business out to a third-party changes a fixed cost into a variable cost. More to the point, ignoring the cost of proper risk management is hardly an answer.

“The ability to do the business that the entity wants to do is of course related to the ability to process it from a risk-management and operations perspective,” added Gordon.

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