Major regulatory changes, evolving market structure and funding challenges are making capital efficiency more imperative. Against this backdrop, the economics of derivatives and cash activities are being reshaped. OpenLink’s Mark Abrams explains how a holistic approach to risk management — especially in regard to counterparty risk and collateral management — can play a pivotal role in improving your firm’s efficiency and maintaining its competitiveness.
Capital. If your organization is a bank, regulators want you to hold more of it. And, irrespective of whether you’re on the sell side or the buy side, your trading counterparties effectively want more of it from you in the form of collateral. Meanwhile, a generally less profitable market environment and tighter capital markets are making it less readily available to you. Any way you look at it, capital is becoming a scarcer resource.
The net effect of a whole host of new regulations will be to require many financial organizations to use their capital more efficiently. For example, Basel III imposes increased counterparty risk charges, minimum capital ratios, and tougher liquidity and funding requirements. Analysts estimate that the total short-term liquidity and long-term funding shortfalls among U.S. and European banks alone will amount to several trillion dollars over the next decade.
Meanwhile, both the Dodd-Frank Law in the U.S. and MiFID II in Europe further encourage the migration of Over-the-Counter (OTC) derivatives trading from bilateral clearing to clearing via a central counterparty (CCP). Margining-related considerations will have a major impact on the economic merits of a trade. They will, therefore, become a key determinant of where, and through which intermediary, a particular trade should be executed. For those more complex derivatives that continue to be traded bilaterally, measurement and management of counterparty risk will also have a profound effect on pricing and the economics of the trade. Overall, the viability of hedging strategies that historically may have been considered no-brainers will need to be reassessed.
A new reality is emerging…
Many organizations have started to address these kinds of issues. Commercial models are being rethought and business lines that potentially incur relatively high regulatory capital charges are being jettisoned. Balance sheets are being restructured. Organizations are seeking more optimal liquidity and funding profiles.
High-level approaches will certainly help support profits and return on equity. But, in our view, they need to be augmented with complementary efforts that address efficient use of capital around counterparty risk and collateral management.
The need for a heightened focus on counterparty risk has been highlighted in recent months. For example, following one rating agency’s downgrade of the U.S. government’s credit rating in August 2011, some market participants were sent scrambling. They belatedly discovered that the terms of their credit support annexes (CSAs) with some counterparties required them to find alternative collateral when the sovereign’s rating fell below AAA. More recently, rapidly widening spreads among certain peripheral euro zone government debt triggered widespread concern and uncertainty about if, when and how European clearinghouse’s margin requirements might jump.
One recent study estimated that collateral management inefficiencies — including issues such as an inability to manage collateral centrally due to an incomplete picture of securities and cash held in separate silos, needless redundancy and duplication of processes and resources, and inadequate internal transfer-pricing mechanisms — cost the financial industry more than $5 billion annually.
Could the broadly inefficient use of capital (as well as market panic and forced selling) that resulted from these recent US and European market events been mitigated? The answer, we believe, is an unreserved yes — for instance, by implementing a more rigorous approach to collateral management in which real-time information about activity and CSA terms with different firms is accessible and analyzable. Maybe then, those firms that had been unaware that some of their CSAs required both issuer and deliverable securities to maintain a triple-A rating, could have instead preemptively shifted their business to other firms with less onerous CSAs. Or, perhaps the firms could have better prepared for the possibility that they would need to post additional collateral.
Similarly, when considering variation margin on exchange-traded instruments, understanding what collateral you have and where it’s posted can help you identify the optimal way to meet your margin call — allowing you to weigh the relative advantages of using other securities posted with a clearing broker, versus depleting cash reserves, liquidating other trading positions, or even using a third-party collateral transformation service.
…and the future is fast approaching
As derivatives and cash activity increasingly migrate to central counterparties (CCPs), the economics of trades will fundamentally change — costs that were previously implicit and hidden at execution become upfront, visible and potentially larger in force. In the U.S., for example, regulators estimates that when implemented, the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank) could necessitate up to $2 trillion of “new” initial margin. This means that if not addressed, inefficiencies around collateral management that currently cost the industry billions of dollars each year will represent even greater financial and opportunity challenges to profitability in the future.
Pro-forma margin calculation is crucial for any firm that is serious about managing capital efficiently, and in a market climate of low interest rates, modest investment return opportunities and funding challenges, we believe that no firm can afford to neglect taking this seriously. Before executing a trade, you need to be able to evaluate which combination of futures or derivatives commission merchant (FCM, DCM) and clearing house makes the most sense based on your trading activity, the fees charged and the (initial and variation) margin requirements.
Failures among individual firms over recent years have painfully demonstrated how vital a role margin analysis and collateral management play into a broader framework of integrated risk management. So, for example, pro-forma margin calculations should take account of your overall trading book and factor in consideration for potential cross–margin netting where possible. What’s more, the interdependencies of financial markets and the multi-faceted nature of some firms’ businesses make a compelling case for the need to have a truly enterprise-wide picture of all of your counterparty exposures.
After all, it’s not inconceivable to have exposure to a particular firm by virtue of it being an underlying in a derivative trade, a bilateral counterparty, a clearing merchant and a member of a CCP, at the same time. Without knowing what your net exposure is, how can you make the most informed trading and risk management decisions?
Over recent years, some larger banks have created credit value adjustment (CVA) desks in order to price and manage net counterparty exposures. The CVA concept is integral to Basel III. More broadly, we believe that those firms that embrace the spirit of integrated risk management — either through a formalized approach to CVA management or use of metrics such as potential future exposure — enhance their capital efficiency tremendously.
Final thoughts
Holding too little capital can be problematic — especially in a market environment characterized by heightened volatility and funding challenges. But holding capital to an extent far beyond what is required by regulation and incommensurate with your firm’s enterprise-wide risks can act as a drag on profits, too.
The dimensioning of net counterparty exposures and margin requirements can play an important role in helping drive improved capital efficiency. It is critical to have an integrated approach to risk management that is reflected in everything— from data and business process management, to trade and margin analytics, and to real-time dashboard reporting of firm-wide net counterparty risk exposures and collateral balances.
Central clearing requires more margin, more frequently. Meanwhile, bilateral margin requirements have grown more onerous and complex. Collateral optimization is therefore becoming increasingly important. The days when firms could regard counterparty risk and collateral management as post trade activities or simply “leave it to the middle or back office” are long gone.
