Fund Managers Struggle to Analyze Swap Transaction Costs

Transaction cost analysis — an everyday discipline in the equities and fixed-income markets referring to the total expense involved in completing a transaction — is now becoming more important to swaps players who need to reap the same benefits as their traditional investment peers.

Unfortunately, the US$650 trillion swaps market remains dismally behind other markets, leaving fund managers spending more than they need to while investors are forced to absorb those costs, say swap consultants and specialists. Just how much more they are spending is a difficult question, because there too many variables to draw a concrete conclusion.

However, it’s clear that fund managers should be thinking further than just checking off the compliance boxes of executing orders electronically and processing them through a clearinghouse. The reason: they might be able to accomplish the same goal — hedge their risk — using a futures deal or other basket of securities at significantly lower cost. That spells a higher overall investment performance.

Can they jump right into more sophisticated analysis of transactions costs? Probably not now, or not without solving some challenges. There is plenty of technology available for fund managers to estimate transaction costs for a stock or bond order. Those costs are the explicit expense – that is, fees related to actually executing an order, such as commissions — and the implicit costs related to of how much their trade may impact the market potential causing them to pay too much for a purchase order or receive too little for a sale. Armed with such information, fund managers can determine whether or not they want to complete the stock or bond order. And if they do, they will know on which trading platform or exchange, when and just how to slice up orders during the day.

Full Solution Lacking

Not so in the swaps market. With no end-to-end solution likely in the immediate future, all fund managers can do in the meantime is rely on automated tools with limited functionality at best or Excel spreadsheets in a pinch. “There is no equivalent to Expedia.com to analyze just how much the same transaction — or trip –would cost,” esays Harold Wright, a consultant with Cleartrack, a consultancy in Brunswick, NJ specializing in customized technology for clearing over-the-counter swap transactions.

The reason: there are so many variables. Fund managers would need to know how much it would cost them to trade on a particular swap execution facility, how much to clear through various futures commission merchants (FCMs), and how much to clear through different clearinghouses. The collateral requirements alone are a virtually open-ended calculation. Not so for equities and fixed-income transactions where all they need to know are the explicit and implicit trading fees.

“Given the new collateral requirement associated with swaps, derivative transactions will be determined as much by their liquidity, ease of execution and overall cost as they will for their ability to help meet a hedging requirement,” says Will Rhode, director of capital markets research at Boston Consulting Group in New York. In addition to clearinghouse requirements for initial and variation margin required and the types of assets which can be used, there are fees and possibility additional margin charged by FCMs.

Patchwork Integration

Ultimately, the challenge for fund managers is calculation and then comparing the various way of settling their swaps trade. “Conducting front-to-back transaction cost analysis across a range of available venues, protocols, products and clearinghouses while simultaneously sourcing a variety of collateral types, each with its own intrinsic value changes, would require stitching together multiple systems in the front, middle and back office,” explains Rhode. Those systems include applications on trading desks, and clearing and funding units.

The costs of building the necessary technology and data integration are hefty, and third-party vendors and futures commission merchants haven’t come up with any end-to-end products. The commercial provides reportedly aren’t certain there is enough demand. As one operations manager at a New York-based fund management shop tells FinOps Report: “We are focused on compliance requirements, such as executing their orders on swap execution facilities and processing their trades through clearinghouses.”

As a result, the limited technological options that tend to originate with the market infrastructures, and offer only analysis of either trading or clearing costs on their platforms. The CME, for one, is helping traders analyze the cost effectiveness of its deliverable swap futures (DSF) contracts versus over-the-counter interest rate swaps in terms of price, rate and risk. Its goal: to persuade a trading desk that it can trade an equivalent product at a lower cost by using its DSF analytics tool. DSF contracts, according to the CME, can provide the same interest rate exposure provided by OTC swaps while delivering the capital efficiencies and operational benefits of standardized futures contracts. But such an analysis doesn’t account for all the downstream clearing costs.

Clearinghouses, in turn, are also joining the world of pre-trade analysis. LCH CLearnet, for one, says that its Swapclear Margin Approximation Risk Tool (SMART) helps members and their clients estimate the initial margin they need to clear an interest rate trade at the clearinghouse on a standalone basis. Available via a user’s desktop or integrated via an API into a user’s internal applications, SMART shows the initial margin impact of offsets gained from portfolio margining with existing OTC interest rate derivative products cleared through Swapclear, says Cameron Goh, head of product management for Swapclear at LCH.Clearnet in London. Bloomberg has also integrated SMART into its platform.

Prioritizing the Challenges

With the utopia of end-to-end cost analysis a long way off, fund managers will likely focus first on reducing their collateral costs, predicts Rhode. Only then will they attempt to reduce their trading costs or seek the liquidity venue displaying the tightest bid-offer spreads. Even so, the available models such as request for quote (RFQ) and central limit order book (CLOB), don’t make comparisons easy, he acknowledges. Depending on the size of the order, a fund manager could find a better price in an RFQ network instead of a CLOB or vice versa should new liquidity providers such as high frequency -trading firms start making markets in CLOB-type venues.

Jennifer Liu, a principal consultant with New York-headquartered  global financial services consultancy Capco suggests that fund managers prioritize clearing costs. Considering the collateral and funding costs of margins and default fund contributions required by clearinghouses, FCM charges and any additional fees, “Clearing costs represent a very large chunk of the cost of a swap transaction,” she says.

Some larger fund managers are taking rather creative approaches to controlling costs. Instead of shopping around for the most cost-effective clearinghouse, they are relying on what has been coined by some as the “bundled order” approach, says Wright. That means they will clear their block order with a single default futures commission merchant, but subsequently allocate the order to multiple underlying fund clients they will using multiple futures commission merchants — one for each allocation.

Even so, he warns, the result of that strategy can be a mixed bag. Fund managers might benefit from lower total margin requirements, but hey could face higher clearing fees from the default FCM handling the block trade, because the entire trade may tie up a significant portion of its balance sheet and create higher operational costs related to allocating clearing to multiple FCMs. What’s more,  only a handful of FCMs will take on the default risk that a counterparty could go bust before a block trade is allocated . 

Given the swap market’s current nascent state when it comes to transaction cost analysis, it appears that fund managers have only one clear option: do the best you can with what you have. Some effort is better than no effort even if it means relying on spreadsheets or making novel clearing moves.