The Impact of Dodd-Frank on Asset Management Firms

As
a consequence of the Dodd-Frank Act (DFA), the costs of doing business will
increase for the buy side institutions resulting from a marked increase in the
cost of trading in over the counter (OTC) derivatives due to higher collateral
requirements and tougher regulatory requirements. These firms will also have to
counter the additional costs of improving their IT infrastructure as well as
bringing in new IT systems and integrating them into their main systems. The
additional costs, coupled with reducing income, will see firms look at various
cost-saving processes.

One
of the most critical events in the financial services industry to date in the
21st century was the subprime meltdown in US. It not only brought supposedly ‘too
big to fail’ financial behemoths to their knees but shook the entire world
economy to its core. Riding the wave of extreme antagonism towards the
industry, newly-elected US president Barack Obama brought in the Dodd-Frank financial
reform law in July 2010, whose continuing repercussions for asset management firms
are reviewed below.

Regulations Impacting
Asset Management Industry

The
table below summarises the impact of the various provisions of the regulation
on the asset management industry:

Sudeep Mallya, Maveric Systems

The
important parties affected by introduction of DFA are financial institutions
(FIs) with a presence across banking, derivatives and asset management, which
in today’s inter-connected world means almost every major financial giant.

Advisor
Registration and Investor Protection:

Most
firms in the wealth management sector now have to compulsorily enrol with the
US Securities and Exchange Commission (SEC) as a registered investment advisor
(RIA). Even a few exempted ones, such as ‘big ticket’ hedge funds and private
equity (PE) firms, will be subject to regulatory requirements in the form of
periodic submission of specified documents. Permissible limits for excluding
information when reporting to regulatory institutions have been reduced, while the
DFA also aims to ensure that brokers provide equal treatment to all investors.

  • Businesses must conform to stricter reporting requirements which include a
    host of value-adding information such as assets under management (AUM),
    leveraged portfolio levels and counterparty exposures. Loose ends on both
    pre-trade as well as post-trade areas have been tightened.

Systematically
Important Financial Institutions (SIFI) Rules:

Systematically
important financial institutions (SIFIs) must be dealt with carefully. Their
collapse could trigger a cascade effect on others, triggering a financial
crisis similar to that experienced in 2007-08. Currently there are no uniform
rules related to the SIFI group entities in the asset management domain. However
most institutions – through their banking subsidiaries (those which have the same
holding companies) – are subject to increased banking capital requirements
through the Basel III capital adequacy regime recommendations.

  • Both the SEC and the Financial Stability Oversight Council (FSOC), an
    entity set up post-crisis, plan to include many hedge funds as well as highly-leveraged
    traders as ‘systemically important’, making them subject to higher levels of
    supervision. SIFI entities will now have to be careful when making riskier investments as DFA places restrictions on the bailout of funds. Banks will also need to exercise prudence while investing in such funds, which could lead to higher risk funds moving out of the markets completely.

Credit Rating
Agencies:

Credit
rating agencies (CRAs) were widely criticised for the consequences of the solid
ratings they bestowed on mortgage-backed securities (MBS) and other derivative
contracts. The DFA brings in a plethora of reforms to reshape the ratings
industry, including granting powers to the SEC that would enable it to revoke ratings
awarded by the CRAs if it judges there to be sufficient reason. These agencies now
face public disclosure of the assumptions and data used to arrive at each
rating, and the submission of an annual report on their internal controls. The
DFA created a separate entity, the Office of Credit Ratings, within the SEC to
manage regulations and conduct annual examinations of these agencies. Thomas Butler was named
as its first director in June 2012.

  • While this development does not directly impact on asset management firms,
    it clarifies for them what constitutes an investment grade fund and what a junk
    fund, in turn leading to additional margin requirements to be maintained for
    their positions in each.

Uniform Fiduciary
Duties:

A
uniform fiduciary duties standard was proposed by the DFA and it is up to the
SEC to take it forward. This rule implies that the advisor is a fiduciary
person/entity who puts investors’ interests first and they are held liable for
any failure to protect their clients’ interests.

  • There are no major business impacts for firms, although when and if this
    proposed standard gets enacted they would be held liable for wrong advice to retail
    customers and could even be penalised.

Derivatives Trading:

Trading
firms have to deal with a newer set of market participants in the form of swap execution
facilities and central clearing parties. Swaps must be serviced on a daily
basis, in the form of the variation margin or mark-to-market that previously applied
only for exchange traded-derivatives. This means a higher collateral
requirement, implying adverse effects on volumes of trades as well as their
pricing.

Firms
must also maintain a repository of all their trades for at least five years
post-execution, meaning increased demand for the costly procedures of data
warehousing and data security. Additional costs are incurred in maintaining the
daily mandatory position reporting. This regulatory change was effected primarily
to ensure that all parties in the transaction are informed of other parties’
mark-to-market position.

  • FIs dealing in non-standardised products such as swaps after the inception
    of this regulation will be required to do real-time market position estimations
    and post collateral.

Executive
Compensation:

A
primary cause of the subprime crisis and the subsequent global meltdown was
attributed to executive compensation linked to sales of OTC derivative
products. Shareholders now have a say in compensation levels for the chief
executives (CEOs) of publicly-traded firms. DFA also introduced rules on
incentive-based compensation arrangements, which prohibit FIs with assets in
excess of US$1bn from adopting compensation programs that expose them to
unsuitable risk or material financial losses.

  • Most of the big names in the asset management space lost their top-performing
    fund managers to hedge funds after the advent of these regulatory requirements
    and it remains to be seen how this plays out in future.

Overall Impact

Independent
consultants, who perform studies on the readiness of FIs to adhere to DFA
guidelines, are gung-ho about sell-side firms but not overly optimistic about
buy-side firms.

Apart
from these regulatory burdens that asset management firms must accede to, they
will also have to comply with additional rules to function in European markets.
The European Market Infrastructure Regulation (EMIR) introduces a new market
entity in the form of central counterparty, which acts like an exchange between
the two parties of an OTC trade. European regulators too have stamped their
authority on the excessive compensation culture by introducing the Alternative
Investment Fund Managers Directive (AIFMD).

Along
with DFA, further rules are being discussed extensively in the industry. Prominent
among them is the Volcker Rule, which requires banks to substantially reduce
the proprietary trades they undertake. As banks are important customers for
asset management firms that deal in OTC derivative products it is presumed that
they will take a huge hit on their trading volumes generated by banks.

Seizing the Opportunity

The DFA sets its core principles in financial stability
and consumer protection. Modifications to the existing infrastructure will lead
to a stronger competitive position. Post-subprime crisis, the asset management
industry was in doldrums; the only way that the industry could redeem itself
was through enhanced governance, risk management and operational transparency
in asset management. Significant changes are required in the operating models to
propel the industry towards unrelenting, long term performance, deliver
investor returns and meet regulatory expectations.

The
advent of DFA may see the cropping up of new transparent derivatives exchanges.
Some firms could garner benefits from re-organising processes/systems, by
exiting non-core businesses while concentrating their efforts on the core
businesses on risk management strategies.

Any
pressure on banks to consider lending only to risk-worthy asset management
firms would lead to only less risky funds surviving DFA. With the higher
influence of technology-led solutions, the Act may lead
to increased adoption of technologies like ‘thin-client computing’ or software
applications that use web based interfaces. Although such technologies are already
widely used an explosion of the use of these technologies in financial services
would substantially further reduce the cost of these services.

With
the mushrooming of regulation organisations are faced with two options.
Firstly, to pass on the costs to customers and face the risk of undermining
confidence in the markets when it is still fragile. Secondly, to take the Act
as an opportunity to shape strategy that improves firms while bolstering market
confidence.

Conclusion

Is the Act a precise step or a step too far? Two highly divergent views emerge.
For some DFA symbolises the systemic response to excessive capitalism. For others,
including the FIs themselves, it will stifle the future so much that market could
stagnate for some time. The regulatory burden threatens to make the cost of
doing business prohibitively expensive, while some grey areas in the Act still
need clarification. The pace of the progress on DFA has been sluggish with only
around 40.2% of the rules having been finalised as of 12 September 2013.
 

Most
of asset management firms’ concerns about the Act will soon disappear once successful
enactment kicks in, while systems and processes will be reinvigorated by the
introduction of new set of reforms. While short-term concerns about additional
collateral requirements act as a drag, the manner in which firms are able to
rationalise their costs and sustain profitability – albeit it at lower levels
for some time – will determine how they fare in future.

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