Germany Jumps at Derivatives

New regulations open opportunities, but strict risk management rules force asset managers to overhaul their front offices.

For the first time, fund managers in Germany are taking on a wider variety of derivatives to boost investment returns, but stringent new risk management guidelines call for radically revamping front-office systems, which could delay the launch of funds that comply with the regulations.

Financial regulators in Germany have always viewed derivatives with a cautious eye. While securities regulator Bafin does not share the view of investment guru Warren Buffet—who famously described the instruments as "financial weapons of mass destruction"—it had until recently only allowed asset managers in Germany to invest in derivatives to hedge risk exposure within their portfolios.

This all changed with the introduction of the Derivatives Regulation (Derivateverordnung) in February 2004, which came into force in conjunction with the Investmentgesetz (InvG) legislation. The Derivatives Regulation allows fund managers to invest in the full spectrum of derivatives products. But to do so they must obey strict risk management rules, which place limits on market risk and counterparty risk and require fund managers to install management and control systems in the front office to monitor the increased risks associated with derivatives. The funds had an adjustment period, which lasted until February this year.

Philippe Carrel, global head of alternative investments at Reuters in New York, says asset managers in Germany have "jumped at the chance" to begin updating their front-office risk management systems to comply with the rules.

Carrel says increasing pan-European competition in the asset management industry has given German fund managers a strong incentive to offer their institutional clients the opportunity to invest in derivatives and structured products. The European Union's Undertakings for Collective Investment in Transferable Securities (Ucits) III directive has extended the range of financial instruments in which funds are able to invest and introduces a "European passport" system to facilitate cross-border activity within the European Union. This opens up opportunities for hedge funds and asset management firms based outside Germany to vie for market share with the country's leading fund managers.

"This [Ucits III] is a new deal," Carrel says. "You are going to see old business models going out of the window and new business models starting to flourish. A passport-free Europe is becoming a reality. If you are an asset management firm that does not offer German investors market-neutral funds [which contain derivatives], someone else will do it."

Risk Control

Frankfurt-based Metzler Investment built a new risk control department to comply with the Derivatives Regulation in early 2006, using a risk management system developed by RiskMetrics. The Frankfurt-based asset manager, which has €30 million ($40 million) under management in a variety of equity and corporate bond funds, took a year and a half to make the risk and control department fully operational.

"Before the derivatives rules we did not need to carry out value-at-risk (VaR) calculations. Now we have to monitor the quality of VaR calculations on a daily basis through back-testing," says Ruth Boettcher, head of risk management at Metzler Investment.
Metzler's risk control department is split into various teams. The original risk management team, which consists of three people, carries out VaR calculations and stress-tests the portfolio. This involves the use of historical simulations and Monte Carlo simulations. The risk team works alongside a data management team, which consists of three people, and a legal and compliance team comprising four people.

"You have to develop all the interfaces to internal systems—it was hard work," says Boettcher. "If you have a new product, you have to route it from the back to front office and into the risk management system to make sure [it is compliant with the regulations]. We have a big IT team and we are working every day on the interfaces because we need a lot of automation in order to avoid manual processes."

In addition to carrying out daily VaR calculations on investment portfolios, fund managers have to obey strict rules on pre- and post-trade transactions to ensure they do not fall outside the regulations. Front-office systems must monitor a fund's exposure to individual stocks and share-price indexes, currencies, and bond issuer and counterparty credit risk. Asset management software company Aquin Group and financial services software provider Charles River Development are among the vendors helping German fund managers comply with these rules.

Aquin Group has installed its MIG21 Global Investment Compliance system at several major asset management firms in Germany, including DWS, a subsidiary of Deutsche Bank, Union Investment, Allianz DIT and Com Invest.

Charles River has installed its Investment Management System (IMS) at six institutional and retail asset managers in Germany. Siegfried Huegemann, senior account implementation manager at Charles River, says the IMS—which incorporates n-tier service-oriented architecture to support front- and middle-office systems—enables vendors to meet three sets of compliance rules: legal and regulatory rules laid down by Bafin, contractual or mandate rules dictated by a client, and internal rules based on a fund manager's asset allocation models.

"The Derivatives Regulation sits between two components of risk—first and foremost the credit risk, and also market risk," Huegemann explains. "If you have a serious violation, you have to report it to Bafin. Quite often, asset managers have to manage as many as 25 different portfolios and they are not sure if they do comply with the regulations or not. Our system checks against a fund manager's account positions and lets the company know if an order violates the regulation's compliance rules."

Huegemann declines to name the asset management firms that have incorporated the IMS software into their systems, but he uses the example of a fund manager investing in exchangeable bonds to demonstrate how the system works. "Asset managers have to consider both market and credit risk. A fund could have a 10 percent limit on the value it can invest in a single issuer within its portfolio, such as Daimler Chrysler. This limit is dictated by the regulatory rules," he says..

"If the firm already has an 8 percent stake in Daimler Chrysler, it may wish to buy an exchangeable bond issued by BMW that can be exchanged against shares of Daimler Chrysler. The details of the BMW bond and the exchange rate can then be input into Charles River's IMS, enabling the asset management company to control the total issuer concentration of Daimler Chrysler. This enables it to avoid violating the InvG rules limiting exposure to a single issuer to 10 percent. The asset manager can increase the issuer concentration of Daimler Chrysler by an additional 2 percent only."

Huegemann says IMS can be adapted to meet the specific needs of an asset management firm, which may obtain trading data and instrument data from a variety of providers such as Reuters or Bloomberg. "We can adjust to the client's environment and integrate with it accordingly. To that end, we can also do pre- and post-trade compliance according to a predefined set of rules for particular security types, regardless of the data set. Without such an open system, it would be challenging to change predefined compliance rules when the regulatory landscape changes," he says.

However, Reuters' Carrel says German fund managers' primary challenge is integrating risk management processes into their internal and external systems. "Ensuring connectivity with order management systems, order routing, prime brokers and different execution venues is critical. Today, fund managers have systems for exchange-traded products that need to be updated to account for over-the-counter derivatives instruments as well. It is not just a case of buying a system and getting into a trade. You have to be able to aggregate risk and valuations. There is the control of static data. You have to change the workflow to have a single view of OTC and exchange trades in one place," he says.

Carrel expects these technical obstacles to hamper German firms' ability to launch funds containing derivatives. "It will be a struggle to start off with this year. Typically, firms get into a business, see the issues and then update systems and workflow. It is usually a much more reactive process," he says.

Source - http://www.watersonline.com/public/showPage.html?page=457147
Publish Date - July 1, 2007