Investment banks' reduced ability to do principal trades as a result of the Volcker Rule may inadvertently hit transition management services, says Nick McDonald, a principal responsible for transition management consulting at Mercer in Hong Kong. The planned Basel IV capital-adequacy regime is also likely to have an effect on this business.
Moreover, the forthcoming rules may impose stricter requirements in terms of transparency on firms that use external liquidity sources for transition management, argue broker-dealers.
Transition management* (TM) – a relatively nascent business in Asia – is the execution of a change in investment strategy across multiple asset classes and asset managers, such as combining two funds, liquidating a fund or shifting asset allocations.
Broker-dealers have traditionally had something of an advantage over asset managers or custodians providing TM services, says Michael Syn Hsien-Min, chief operating officer at DBS Asset Management in Singapore. That’s because broker-dealers can more easily warehouse risk to help offload, say, hard-to-sell assets in a portfolio and thereby complete a transition within a client's desired timescale.
The downside of this capability is that broker-dealers have the most incentive to front-run trades, says Syn, whose firm is to merge with Japan's Nikko Asset Management. “There’s a very fine line between front-running and pricing the market to absorb the risk [of a client’s trade],” he says. “Up to a certain point, the dealer is just making a concession for a block trade – beyond that line, they’re pushing it and making some money out of it.”
However, banks are now less likely to take illiquid assets onto their books due to the Volcker Rule – part of the US's recently signed, but yet to be finalised, Dodd-Frank reforms – which effectively bans bank proprietary trading, says McDonald. They will admittedly still be able to trade on a client's behalf, but the planned Basel IV capital-adequacy rules will potentially reduce the amount of risk they can have on their books.
That said, the new laws will not only affect broker-dealers' TM business, but also that of the custodian firms and asset-management companies, which use networks of broker-dealers and other liquidity sources to execute transitions, says McDonald.
Moreover, broker-dealers typically only do principal trades for a relatively small part of each portfolio transition they carry out, so they argue this is not a major issue.
"We do not believe that these regulations will constrict our ability to provide transition services to clients or affect the competitive advantages the broker-dealer model provides,” says Richard Surrency, head of Asia-Pacific transition management at Morgan Stanley in Hong Kong. “At most, it may limit some non-core services around the warehousing of risk to clients.
"Morgan Stanley supports any legislation or recommendations that create enhanced levels of transparency and safety within financial markets, and will adapt our transition management service models to accommodate any such legislation,” adds Surrency.
“Based on an initial review of the [Basel IV and Dodd-Frank] regulations, we do not expect significant changes to our business model, because we already provide agency-only execution services to our client base in an overwhelming majority of the transitions we undertake, providing transparency across all transactions,” he says. “In Asia, the potential withdrawal of our ability to warehouse risk will not affect our business."
Another Hong Kong-based transition management specialist at a broker-dealer makes a similar point, noting that his firm only enters into principal positions with the client's consent in less than 5% of the total transitions it undertakes.
Meanwhile, the anonymous specialist argues that the forthcoming regulatory changes could mean tighter requirements for transition managers that use external execution platforms – ie, non broker-dealers. This might include custodian firms such as Northern Trust or State Street, or asset managers such as BlackRock or Russell Investments.
“Where transition managers use intermediaries for executing client portfolios, we expect the Volcker Rule and Basel IV will require more transparency in terms of execution pricing, commission sharing and other arrangements that may be in place within these external agent execution platforms,” says the unnamed executive.
That said, notes DBS AM's Syn, broker-dealers tend not to put trades through rival broker-dealers, so they may not necessarily obtain the best prices, whereas custodians and asset management firms will use any liquidity sources that are available.
On the other hand, the more liquidity channels a transition manager uses to make changes to a portfolio, the more easy it may become for others to trade against that portfolio.
Clearly, then, asset managers and asset owners must carefully weigh up the pros and cons when deciding on a transition manager, says Mercer's McDonald.
"Some [institutions] treat transition managers like asset managers, in that they have a beauty parade," he says. "But you need to spend time with the transition manager, you need to know what their execution capabilities are, what are their sources of liquidity, what risk tools they offer."
Every transition manager is different, adds McDonald, so the fit will depend on the client's business and the circumstances at the time.
* Readers can refer to the December issue of AsianInvestor magazine for a more detailed feature on the state of the TM market in Asia.