The derivatives are increasingly finding their way in to the portfolios of non-bank asset managers, it causes concern for regulators.

Asset Managers

How asset managers should properly unwind

As concerns regarding derivatives and managing such asset managers during crisis is the subject of a white paper from Federal Financial Analytics on addressing these issues titled “The Future of Asset Management: New Systemic Standards and Their Strategic Impact.”

The paper considers how certain asset managers should properly unwind “ensuring orderly resolution under stress at a firm.” In other words, if a fund manager were to implode there should be methods to dismantle the positions, or defuse the time bomb, without further damage to investors and the world economy. In particular as popular asset managers such as Warren Buffett and Bill Gross utilize large derivatives positions, many of the positions with a significant degree of exposure to interest rate volatility to generate returns, those positions could be forced to be unwound in haste, particularly in a crisis situation.

Capital required by a bank or asset manager

Rather than make decisions during a crisis — the worst time to address the worst case risk management — the Federal Reserve is in the process of planning for this process on several fronts. Separate analysis notes that while it is attempting to address margin requirements, the amount of capital required by a bank or asset manager to hold in reserve in case of significant loss, the reality is this effort is likely not to be the key to solving the problem. The required assets being discussed, around 1 percent of the notional value of the derivatives exposure, is far from sufficient if a worst case situation were to occur.  As such, the Fed is also forcing reluctant banks to develop a robust breakup plan.  The banks had previously submitted a 35 page document to regulators that was laughingly short.  So long as the regulatory regime under Janet Yellen has sufficient backbone to stand up to the banks, regulators could require the banks to model a worst case derivatives scenario and then plan a bankruptcy process now, shedding toxic assets, rather than wait until the crush of a crisis. Waiting for the crush of a crisis benefits the banks because another bailout is the most probable path.

For its part the white paper focused significantly on the type and quality of assets and appeared to shy away for calls for enhanced margin.  It did not focus on recommendations to solve the problem, but just outlined the structure for consideration of the problem. One issue the paper addressed was regulatory arbitrage. While it didn’t offer solutions, it did highlight a thorny issue. It is framing the decision that will be the first step in the process apparently.