Aviva Investors, one of the largest asset managers in the U.K., is an active user of derivatives as a component in the investment solutions that it offers to insurance companies, pension funds and other institutional investors. In this interview, the latest in a series of buyside profiles in MarketVoice, Barry Hadingham, the company's head of derivatives and counterparty risk, talks about some of the current challenges Aviva Investors is facing in both the cleared and uncleared derivatives markets and explains why his firm may opt to move its clearing to the U.S. after Brexit.
Aviva Investors is the global asset management business of Aviva plc, the U.K.'s largest insurance company, and manages more than £346 billion ($423 billion) in assets for its clients across a range of fixed income, equity, real assets and multi-asset funds. The company is particularly well-known for the investment solutions it provides for insurance companies and pension funds that need to generate returns that match their longterm liabilities.
Barry Hadingham is the company's head of derivatives and counterparty risk. Based in Aviva Investors' headquarters in London, he oversees the company's use of derivatives in its investment strategies. He also oversees the company's engagement with key elements of derivatives-related regulatory change, including the introduction of mandatory clearing and the implementation of Dodd-Frank and the European Market Infrastructure Regulation.
In terms of asset classes, Aviva Investors tends to be most active in fixed income derivatives, and the bulk of its trading is in interest rate swaps and other over-the- counter instruments. On the equity side, the company is a heavy user of exchange-traded equity futures and options as well as equity volatility derivatives in the OTC markets.
The company's clients are primarily European and predominantly hold assets denominated in sterling and euros. But Aviva Investors will trade in almost any currency for strategies that have the flexibility to pursue return in any part of the world. The key criterion is whether the market has sufficient liquidity to support the size of the trades that Aviva Investors is putting on. "If you look at what we trade in our global macro funds, it could be in any currency and in any market, as long as we can find a scalable and efficient way to get into the market," Hadingham said.
Brexit: Contingency planning
One of the biggest challenges that Aviva Investors faces is the U.K.'s withdrawal from the European Union. At present the company relies on two London- based clearinghouses—LCH Ltd. and ICE Clear Europe—to handle the bulk of its cleared derivatives. The problem is that the European Union and the U.K. government have not reached an agreement on the post-Brexit regulatory status of U.K. clearinghouses. Under the existing framework, EU regulators permit EU customers to access U.K. clearinghouses because they are subject to European regulations. It is not clear, however, what the regulatory landscape will look like after Brexit, and there is a risk that Brexit will disrupt cross-border access to U.K. clearinghouses.
As a result, Aviva Investors is making contingency plans for where it clears derivatives. According to Hadingham, one alternative is to look across the channel. Eurex Clearing, the largest derivatives clearinghouse on the continent, offers clearing for interest rate and equity derivatives and is actively campaigning for business from European asset managers.
“The issue is, given the concentration of clearing members who am I going to dilute it with? I can only go to one of those top players and the whole market is dominated by those few firms. It has potentially created another ‘too big to fail’ problem.”
Barry Hadingham, Aviva Investors
"There are broadly two strategies that we could adopt in terms of Brexit," Hadingham said. "The first one is you move onshore in Europe for clearing. But you have to evaluate what's available onshore and whether that meets your requirements and covers what you need to do for your clients. And if that's not the case, you need to look at alternatives."
A factor for Aviva Investors is that Eurex does not clear interest rate swaps in the range of currencies that it needs, he explained. For example, its global macro and absolute return funds have the latitude to pursue investment opportunities in any currency and in any part of the world.
"If you're predominantly concerned about clearing euros, it's fine to look at someone like Eurex," he said. "If you run broad-based global strategies, like we do, then the range of currencies isn't there."
For that reason, Aviva Investors might consider the U.S. as an alternative, he said. CME Group, the largest U.S. clearinghouse, clears interest rate swaps in 24 currencies, including several emerging markets currencies such as the Mexican peso and the Korean won, versus just nine currencies at Eurex.
For a similar reason, Hadingham sees ICE Clear Credit, the clearinghouse based in New York, as a potential alternative to LCH SA, the Paris-based arm of LCH Group, for clearing credit default swaps. ICE Clear Credit clears a wider range of products and it has a deeper pool of open interest. And like CME Clearing, it is currently deemed to be subject to "equivalent" regulation by EU regulators, which means European clients can use those clearinghouses without violating local rules.
There is another important reason why Aviva Investors is looking to the U.S.; the company already has the infrastructure in place. Hadingham explained that after the U.S. implemented Dodd-Frank, Aviva Investors decided to opt into clearing in case some of its clients became subject to the Dodd-Frank clearing requirements.
"Right from the start, we've always had U.S. and U.K. clearing arrangements in place," he said. "The reason being that we weren't sure whether we might fall under Dodd-Frank under certain circumstances."
One could argue that there is a third alternative, namely, to reduce or even eliminate the use of clearing wherever possible. But Hadingham said that is not an option because Aviva Investors does not want to give up the benefits of clearing, such as more liquidity and better pricing.
"In certain markets, it is becoming increasingly difficult to get trades done if you don't clear them," he said. For example, in non-deliverable swaps in emerging market currencies, "it's relatively easier to find liquidity in cleared than uncleared."
Greater use of clearing also supports the company's drive to reduce the operational complexity of derivatives trading. Aviva Investors has moved to standardized dates for its interest rate swaps wherever possible, which allows the company to net down its positions and streamline its operations. For example, if the company enters into an interest rate swap based on the standard IMM quarterly dates, and then adjusts its position a few weeks later with another pegged to the same dates, the two positions can be netted down through clearing.
"Clearing has driven a number of changes for us," he said. "We've achieved far greater standardization. For example, in the past we might do a five-year swap, and then when we're rebalancing the portfolio, we do another five-year swap and then another, and so on and so forth. We're now trading to IMM dates and getting that standardization in the book, which then means that it is much easier to compress and collapse those trades down. So not only do you end up with fewer positions, there's a lower back-office cost and less complexity."
UMR: Preparing for phase five
Although Aviva Investors is a fan of clearing, not all of its derivatives can be cleared. For that reason, the company is actively preparing for the global implementation of initial margin requirements on uncleared derivatives. Phase four, which took effect in September, covered entities with €750 billion in average aggregate notional amounts. Hadingham said Aviva Investors' clients are in scope for phase five, which is due to take effect in September 2020 with some now in scope from September 2021.
That phase will capture all entities with more than €8 billion in derivatives, which in practical terms means that it will cover a significant proportion of asset managers. This past July the regulatory community agreed to split this phase into two groups. Those that have €50 billion or more will remain subject to the September 2020 deadline, but those below that threshold will have another year to prepare.
Hadingham commented that this decision should be helpful to asset managers and their clients. Some of his clients are above the €50 billion threshold, others below, but they are all wrestling with the complexities of implementation. One of the biggest challenges is the large number of legal and operational arrangements that need to be put in place with custodians and counterparties.
"You need those agreements in place with every single counterparty. The more counterparties you have to provide liquidity, the more of those you need to negotiate. For example, if you have 10 counterparties, there are five or six agreements that you need to negotiate for UMR, per counterparty, per client. That's 50 or 60 agreements alone for one client."
This is creating what Hadingham called "bottlenecks" across the industry because of the demand on the industry's legal resources, and he warned that some custodians may have considered, prior to the recent changes for phase five, implementing a cutoff from June 2020 in order to prepare themselves for the September deadline.
Even though preparations for UMR implementation are not yet finished, Hadingham is already looking ahead to the next challenge—margin optimization. Once the new arrangements are in place and initial margin is being posted on all derivatives, both cleared and uncleared, the margin requirement will need to be factored into the cost of entering a new position. This has knock-on effects in investment strategy: is a bilateral swap the best way to implement an investment strategy? Or would another instrument, such as a cleared swap or a listed future or a government bond, offer a better return after adjusting for the cost of collateral?
To make this type of calculation, Aviva Investors is looking at analytical tools developed by several technology vendors, he said. This type of tool is particularly important for firms like Aviva Investors that have clients with directional portfolios. Unlike a bank that is on both sides of the market and therefore has more opportunity for margin offsets, a pension fund typically will be on one side of the market, and its positions, like its liabilities, will tend to go out very far in time. That means margin requirements will be quite high, and reducing the amount of margin can make a big difference in the performance of the investment strategy.
"If you look at what we need to do to manage this, there's more and more margin going into the system, and that has to come from somewhere," he said. "That means you need to work out your liquidity requirements and work out if using derivatives with all this margin is actually the best option in terms of implementing the strategy you're trying to implement."
Hadingham declined to specify which tools Aviva Investors is considering but he emphasized the importance of this type of analytics to traders and portfolio managers as the uncleared margin requirements take effect. "We see that as absolutely crucial to the management of this process as we move forward, in terms of optimizing the margin that we're running and allowing our portfolio managers to understand [the margin requirements] in advance of putting trades on."
Concentration risk: Concern about porting
Hadingham says Aviva Investors is a "fan" of clearing, but there is one aspect of the clearing landscape that greatly concerns him—the concentration of market share among the major clearinghouse members.
Since the 2008 crisis and the drive for greater adoption of clearing, the regulatory community has set higher standards for clearinghouse risk management, and the major clearinghouses now have enough resources to absorb the simultaneous default of their two largest members. The problem is that the number of clearing members has declined considerably over the last decade or so.
Hadingham is worried that if one or more large clearing members fail, clients of the defaulting members will not be able to move their positions to another clearing member. This type of transfer, known as "porting", has worked during past experiences with defaults, but in the current clearing marketplace there are only a handful of large players with the ability to take on large customers, particularly with respect to cleared swaps. For that reason, he is skeptical that porting will work.
He acknowledged that the clearing system is structured so that client positions and collateral are segregated from the clearing member's accounts. That provides some protection in case of a member default. But his concern is that if clients cannot port their positions to a new clearing member within the agreed timeframe, the clearinghouse will be forced to close out those positions, liquidate collateral, and return the cash to the clients. That would knock those derivatives out of their investment portfolios and destabilize the expected performance of the investment strategy. That also would force clients to go back into the market to reestablish their positions, which could be very expensive if markets are stressed.
"If you can't port and there's nowhere to go, then they [the clearinghouses] would have to liquidate the positions and potentially the collateral as well," he said. "For our insurance and pension clients, if the bonds that they've posted for initial margin have been liquidated, we would have to go and buy them back."
Aviva Investors has explored the potential to establish relationships with a wider range of clearing members, he said, but expanding the range of clearing arrangements will not solve the problem given the concentration of market share.
"We run a relatively concentrated clearing model," he said. "And I have considered whether diluting that would help to solve the problem. The issue is given the concentration of clearing members who am I going to dilute it with? I can only go to one of those top players and the whole market is dominated by those few firms. It has potentially created another 'too big to fail' problem."