LONDON Money managers are trying to reduce the number of counterparties to focus on bigger and stable banks to secure their assets and payments as they plan for the worst-case scenario in the euro zone debt crisis.
Uncertainty about the outcome of the two-year-old debt crisis -- with the worst-case scenario being a break-up of the 17-nation currency bloc -- and shrinking liquidity are complicating the life of asset managers, who are already struggling with diminishing market returns.
"It's been an operational challenge. We've reduced the number of counterparties significantly ... over the past 2-3 years it's been massive," Rod Paris, head of investments at Standard Life Investments (SLI.L), told the summit on Wednesday.
"We tend to deal with national champions, banks critical to the payment system of the country. Smaller banks have fallen away. But there are newcomers in the list too, that is emerging market banks. We're looking at more geographical spread."
Standard Life has also stress-tested its portfolios against all the scenarios, Paris said.
The UK Financial Services Authority told British banks late in November to plan for a potentially disorderly break-up of the euro zone, or the exit of some countries, as part of their contingency planning.
Banks have told Reuters there is already rigorous testing of systems going on, including for a possible euro zone break-up, as part of a risk management process that has been accelerated considerably in recent years.
Banks are constantly testing their capital, liquidity and operations, such as payments systems, for risks and as the euro zone break-up threat has risen, they are feeding that risk into their checks.
Sergio Trigo Paz, global head of emerging fixed income at BNP Investment Partners, says the firm is avoiding certain types of instruments whose liquidity can disappear quickly.
"You want to be liquid, you do not want to be long in exotic markets, you don't want to be in Nigerian naira credit-linked notes," he said.
"We avoid trading swaps and these types of derivatives."
Euro zone central bankers are looking at scenarios that cover the possibility of a shock to the currency area that could trigger its partial break-up. The European Central Bank hosted a communications exercise with officials from national euro central banks last month that included a commercial bank collapse scenario.
U.S. BANKS FAVOURED
Some think the ultimate risk is in the banking sector itself. Alan Brown, chief investment officer at Schroders (SDR.L), says the firm is looking for ways to gain market exposure without being exposed to banks.
"One of the ways you can get market position is through swaps. We are less keen on doing swap arrangements, and in terms of collateral we don't want to take cash, we'd rather take bonds. We're pulling up the drawbridge as much as we can," he said at the summit.
"Now we're looking at all swap and other agreements to see if there were to be a change in a currency of a country, would our agreement still be in euros or drachma or lira."
Brown also said Schroders was avoiding using banks that clear euros through peripheral euro zone centers such as Madrid and sticking to centers in core Europe -- preferably Germany.
"Holding euros in a Greek bank in Greece might not be as clever as having them in Germany," he said, adding that a U.S. bank clearing euros in Frankfurt was preferable than say a Spanish bank clearing in Madrid.
Richard Cookson, chief investment officer at Citi Private Bank, said clients favored stronger U.S. banks.
"European banks are having dollar funding and financing problems. We've certainly seen money flowing into stronger U.S. banks," he said.
Schroders' Brown is also braced for the possibility of capital controls in case the currency union breaks up -- as happened between Czech and Slovakia in 1993 when they split.
"If you see a change, there must be capital controls for a period. It's not been the end of the world for Slovakia, it's in the euro," he said.
Stephen Jen, managing partner of hedge fund SLJ Macro Partners, said diversifying prime brokers is one way to reduce counterparty risk. A prime broker -- usually from investment banks -- offers hedge funds clearing, trading and collateral facilities.
"Nothing is assured. You have to think exactly where your money is. What people are doing is to have multiple prime brokers -- you can diversify," Jen said.
"You reduce your risk and leave the minimal margin that you need to leave with them and put the rest in a triple-A rated bank."
(Additional reporting by Carolyn Cohn; For summit blog: blogs.reuters.com/summits;
Editing by Susan Fenton)