For many in the derivatives and financial industry, the current market volatility is reminiscent of the credit crisis just over a decade ago. That financial crisis was the catalyst for a wave of financial regulation (e.g. EMIR and UMR). In a DerivSource Q&A, Phil Simons, Global Head Fixed Income Sales – Derivatives, Funding & Financing at Eurex, discusses how well those regulatory changes enabled firms to deal with the current crisis and what operational changes firms can implement now to address the collateral challenges arising from the current COVID-19 pandemic.
Q: Have the lessons learned from the previous crisis (and subsequent regulatory change) established a better foundation for market participants to navigate this volatility as it pertains to the margin and capital management?
A: Certainly, from a credit perspective, we did not see any Lehman Brothers-style defaults. Over the crisis period, margin levels did increase quite significantly, but that is how the models are designed to work.
From an operational perspective, the cleared derivatives market proved to be efficient and resilient. There were periods of extreme workloads, and clearinghouses had to stay open later for reconciliations and allocations to be completed, but that is to be expected. There is always room for improvement in automating operations, especially post trade. For example, everyone will be looking at how to cut the time it takes to produce reports when dealing with huge volumes.
Overall, the market performed incredibly well, and there is definite validation for the move to central clearing since the last financial crisis. To be able to cope with a significant increase in volumes, the number and the size of margin calls,—and to be able to do all that in an incredibly volatile market, with so many people working remotely is really a very positive indictment of the centrally cleared model.
“To be able to cope with a significant increase in volumes, the number and the size of margin calls—and to be able to do all that in an incredibly volatile market, with so many people working remotely is really a very positive indictment of the centrally cleared model.”
Q: How are firms looking to minimize the impact of the pandemic on capital and margin requirements generally from a post-trade perspective?
Firms are looking closely at funding costs to make sure they have the right securities available to fund initial margin. With the increased frequency of intraday margin calls and increased size of variation margin calls that have to be paid in cash, they need to keep a close eye on cash and collateral management. Firms will want to minimize the number of margin calls, which means rationalizing their clearing brokers and their use of central counterparties (CCPs) to get the maximum netting benefits.
Q: What are some of the current collateral management challenges and consequent operational changes you are seeing amongst your clients?
A: Uncleared or bilateral trades posed quite a challenge, especially with the work-from-home component. Even with delays to the Uncleared Margin Rules (UMR), many firms are looking at whether they could, should and how they would move into voluntary central clearing. A firm needs to look if it has bilateral portfolios that could be back loaded to the CCP to help increase efficiency, for example.
The crisis, however, has put some important countries on credit review, and there have been some significant changes in the value of collateral. This puts a lot of pressure on margin requirements and how firms collateralize their portfolios if they are placing those government securities as margin collateral. There are many variables that need to be constantly looked at in terms of haircuts on collateral, potential downgrades, and what impacts that might have on the type and value of collateral being posted.
When there are massive volumes in the system, it is to be expected that certain processes and reports take longer to produce. Firms must determine which are the most critical parts of the system and look at their overall capacity to make sure that it is scalable, and that they have everything in place to speed processes up if and when they need to do so.
Over the coming months, the industry will review the most appropriate levels for margin to help the process be as smooth and efficient as possible. Even though the models performed correctly, very large increases in margin and big swings in variation margin can put a lot of liquidity strain on clearing members and their clients. Some suggest margin levels should be higher in normal times, so that in times of crisis the increases are not so big.
Q: With an extension to UMR as well as other regulations as a result of the pandemic, do you think firms will take their foot off the pedal when it comes to pushing ahead with changes to meet compliance requirements?
A: Phase 5 and 6 firms under UMR have a bit more time to look at the impacts of the increase in volatility and the increase in margin levels and determine the most efficient and optimal ways that they can manage their business. It will give them the chance to review their current collateral and clearing relationships, and to look at getting the optimal relationships in place.
Collateral optimization and collateral efficiency have become more important. The regulation extension gives these firms more time to look at the most efficient arrangements to minimize any potential problems that might occur in the future, if volatility returns to the market. For example, what to do with unsecured cash or how to convert securities into cash for margin payments in a short space of time. It’s the old question of do you have the right securities, in the right place at the right time.
That being said, these firms will not want to take too long in this review exercise because they know what challenges they faced this time around and during the volatility experienced in March specifically. They have seen that clearing is most efficient from both an operational and a collateral perspective and will not want to wait until the last minute. The regulation extension is offering these firms a little extra luxury of time to look at it, analyse it and hopefully get it right.
Q: As a clearinghouse, have any post-trade operational changes been made to better support new needs in light of the market volatility and increase in margin calls?
A: Our margin model worked exactly as it was designed, so we did not have to make any changes to the model itself. The models are, however, constantly being refined and recalibrated based on the historical aspects of the models so there is always fine tuning to the calibrations.
Q: How have recent changes in funding and financing in the markets impacted the way firms managing their liquidity and margin management?
A: Central banks stepped in quite aggressively to make sure that there was enough liquidity in the market. From a dealer-to-dealer perspective, that seemed to work very well, but the end clients were not able to access the liquidity quite as easily.
Direct access models for the buy side for repo are now firmly on the agenda. That has been efficient and well received in the US under the Fixed Income Clearing Corporation’s (FICC) model. Extending access to the cleared repo market for the buy side in Europe is a very important topic and something that Eurex is heavily involved with.
“Direct access models for the buy side for repo are now firmly on the agenda”.
Q: Looking ahead, how will the conversations and planning amongst derivatives market participants change as result of this pandemic and related market volatility?
A: Firms will be looking at their cleared and non-cleared operational and processing models, as well as key provider risk. Firms that were not able to migrate so easily to remote working will be looking at what additional things they need to have in place to be able to carry on with normal business activity, but from a home office.
With such big swings in the market, funding and financing will become a key topic and people will be looking at what facilities they have in place. There is still potentially a lot of fallout to come, in terms of changes in credit risk in the marketplace. It is a continual process of learning and becoming more efficient and more robust.
Some firms will be looking at this tactically. Perhaps they will move different parts of their business from one clearing broker to another, put in place additional credit facilities, or open up new relationships. From a more strategic perspective and as already mentioned, access to the cleared repo market for the buy side is something that will be high up on the agenda.
The whole relationship between the cleared and the non-cleared could change. Pensions funds have a number of exemptions, but they may now wonder if they should accelerate the voluntary move into the cleared world to avoid being caught out by another potential crisis. Another area of focus will be whether it is possible to move more products into the cleared world, for example FX or credit. The market is always evolving, and it will continue to evolve. A crisis can act as a catalyst to speed up that evolution.