Much attention lately has been focused on margin requirements for non-cleared derivatives, however market participants should also be assessing the strategies for optimizing across their books, and in particular cleared and exchange-traded derivatives (ETD) flow. Lombard Risk’s Lisa Jackson discusses in a Q&A with DerivSource. Register for our webinar May 3 to hear more on this topic.
Q. With the focus recently on the initial margin (IM) and variation margin (VM) requirements for non-cleared derivatives, why do you think firms should focus their attention on optimizing collateral across ETD and cleared derivatives flow? What are the drivers behind this?
A. Regulation is obviously the biggest driver for collateral management change and optimization in particular, but liquidity management is a close second. Collateral is increasingly important for firms as regulators demand more collateralization of trades to manage risks, which requires the front office to put up much more capital and margin to cover their positions. This is a stark contrast to practices years ago where firms simply didn’t have this capital drain or operational burden, and as such, firms are currently focused on making the most of the assets they have.
Using the new VM requirement under BCBS/IOSCO as an example, many organizations such as middle-market firms and corporates have not been used to posting VM on a daily basis, so now they have to put tools in place and look at different sources of collateral in order to be able to move money and collateral each day. To do this, firms need to take a holistic view of their collateral to optimize use of the assets they have when meeting margin obligations for cleared and non-cleared derivatives.
A second driver behind collateral optimization, and in part due to regulation, is the shift for collateral management from the back office upstream to the front office to be more closely aligned with capital and liquidity management. Post-financial crisis liquidity management remains a big focus for firms and as part of this focus, firms are looking to optimize their overall book of collateral to support their obligations and for ETD flow as well as Over-the-Counter (OTC) derivative flow.
For instance, with ETD flow, increasingly firms are looking at which central counterparties (CCPs) offer the better rates in terms of fluctuating interest rates and are also investigating where they can deploy some of the collateral that is under-utilized.
Some firms are taking optimization a step further and looking to push their collateral practices to function more akin to a trading vehicle which may allow them to make a few basis points from optimizing their collateral.
In short, market participants are looking at various optimization methods for cleared derivatives and this is both an internal and external exercise and one driven by cost reduction and the need for efficiency in both capital and liquidity management.
Q. What is the biggest challenge they face as they look to optimize collateral flow as needed for both ETD and OTC flow?
A. The most significant challenge firms face is how to determine which are the best assets to use to meet margin obligations in an efficient manner. Cash is relatively easy to post to meet margin obligations, but firms often incur capital charges on the cash their clients have deposited. Thus, they may prefer to use non-cash vehicles to avoid such charges.
Take a corporate treasury departments as an example. Corporate treasury departments need to mobilize large amounts of collateral at short notice, so for them collateral optimization is crucial to meet these capital demands and especially as they are likely to grow. Another example is energy companies, who have seen extreme market volatility in recent years. If there is a $50-100 million margin swing the next day, they will have to go to the market, price and buy Treasury bills—if that is their collateral of choice. In the ETD space, trades are generally margined on a T+ 1 basis; however, firms really need to know on the same day what their margin calls are going to be. They need real-time information on what their positions are costing in terms of the collateral movement and capital required as this determines the actions they will take with their brokers the next day.
Collectively, this scenario for corporates, energy companies and many other types of firms where they see a steep hike in margin call volume and capital required to meet obligations on sometimes a relatively short notice highlights a big pain point – manual processing. Many firms lack the systems needed for handling collateral cash flow in the ETD space. Firms tend to have systems that handle transactions and the overall margining of a position, but the true handling of the daily cash flow remains very manual and reliant on spreadsheets.
Many US firms operate off spreadsheets or other ad hoc models as they start to grow their business. But as their collateral requirements increase, they find they cannot support their business properly with these manual processes as they lack the scale and flexibility to manage the volume or frequency they require. Therefore, investing in technology is key not only to support scale but also optimization of assets for collateral purposes as driven by the need to be cost effective and capitally efficient.
And some firms make take the investment in technology a step beyond and adopt more sophisticated algorithms to support collateral optimization. In fact, collateral is becoming much more an algorithm-driven business as this is the ideal tool for firms to determine how best to optimize their assets. As such, the use of more sophisticated algorithms is on the rise.
Q. For optimizing ETD flow, what can the brokers/FCMs and CCPs do to help market participants make the most of their assets to meet margin obligations?
A. We see Futures Commission Merchants (FCMs), brokers and clearinghouses stepping up their efforts with clients to address collateral optimization.
For the brokers, traditionally they would take the assets given to them by clients and either place up to the exchange or to be held at their custodian. However, now FCMs are paying closer attention to their clients’ assets to make sure they are being used optimally. For instance, rather than just getting $50 million in Treasury bills to cover margin costs, there might be cash overseas that can be used instead and is more efficient and cost-effective for the client. The focus for both brokers and their clients is not just on covering the margin, but on covering it in the smartest way possible, and not letting assets simply sit with the custodian when they could be deployed to a client’s advantage.
As for the exchanges and clearinghouses, I believe most are aware that there is a need to have an optimized viewpoint across products. For instance, a CCP could assist market participants by allowing for more offsets of OTC IM requirements with similar products, such as Eurodollars, treasury notes or futures.
Q. How do you see the space of ETD optimization evolving in the next 18 months?
A. Generally, I believe firms will continue to look at new methods for decreasing risk and costs, while increasing liquidity and profits. As buy-side firms trade more, the need for proper collateral management will grow, and they will be evolving their collateral operations from a back-office function to be more upstream.
I think a growing number of firms will deploy algorithms to optimize their whole book and pool collateral as part of their wider efforts to better manage liquidity and reduce capital charges and risk. This includes assessing if a firm’s withholding cash is at optimal levels, for instance. Some firms may also review where they are holding their cash and which custodians have the most favorable interest rates.
The trend towards treating collateral as more of a tradeable instrument will also continue as firms increasingly look to improve the mobility of their assets and optimize their collateral in a timely manner. To support this, technology is required so firms can push and pull collateral back and forth quickly but also clearly see where assets are located.
Finally, technology investment will grow as firms need to streamline their processes and revamp systems to enable collateral optimization and support a more efficient collateral management operation. As such, I believe that in the next 18 months firms will be undergoing system reviews and making strategic decision for how to move forward into the new age of collateral liquidity management.
