Whether you are a Phase 6 firm working to monitor your margin to keep under the UMR threshold come September, or a Phase 4, 5, or 6 firm looking to support cross-asset margin management; pre-trade analytics is essential to support the processes and collateral optimisation generally. In a Q&A with DerivSource, both Ingvar Sigurjonsson, managing director, Funding and Collateral Transformation at State Street, and Marc Knaap, head of Business Development at Cassini Systems explain why pre-trade margin analytics and optimisation will be important for all firms looking to take their margin management to the next level.
Q: Let’s start with the drivers. Why do you see an increase in uptake in pre-trade margin analytics and optimisation among both the buy side and sell side?
Knaap: The need to pledge and manage Initial Margin (IM) for uncleared derivatives for many firms is a relatively recent requirement as is the need for margin management, optimisation, and analytics tools to support this process.
IM has been around for a long time within exchange-traded derivatives. Fast forward to today with both the Uncleared Margin Rules (UMR) and the ongoing push for central clearing of derivatives, firms are suddenly managing a much higher numbers of IM, it has considerably increased due to both cleared and bilateral derivatives activities. These significant amounts of IM mean many financial institutions trading derivatives have increased needs, and motivation, to minimise the impact of increased IM and therefore analyse their IM requirements on a pre-trade basis.
The amount of IM in question is not small, the opposite?! For example, firms today may have GBP 1 billion sitting in IM and are not assessing the cost impact on their P&L. This amount of IM sitting around will have increased dramatically over the last few years which is prompting most firms to take pre-trade analytics seriously.
Sigurjonsson: It is not just that regulation is increasing the IM requirement for firms – there is also growing demand for high-quality assets that are eligible to be posted as collateral. To support this new demand, firms need to manage collateral inventory efficiently. If a firm pays too much for collateral or is using assets for margin obligations instead of for alpha-generating activities, the organisation’s bottom line will be significantly impacted. Additionally, we are seeing that front offices are increasingly looking to know the margin impact of their trades and actively manage funding costs.
The margin impact of a trade depends on what is in the portfolio. For instance, putting on a trade with one dealer could cause an IM increase of millions, while putting on the same trade with another dealer could decrease IM because of portfolio offsets available; reducing the overall risk. This is where pre-trade analytics comes in; providing information firms require to make the best decisions from a funding and cost perspective before a trade is executed.
It is no longer good enough to have a back-office algorithm running with no transparency in the front office who manage execution. Buy-side firms need to bring margin optimisation into the front office with specialised analytics and new technology. Pre-trade analytics capabilities enable firms to see the margin impact across all their trade groups and to choose the trades that reduce or minimise their margin requirement overall. In turn, this then enables buy-side firms to reduce funding costs and free up assets that they can use to generate additional alpha.
Q: How does the need for pre-trade analytics and collateral optimisation differ amongst firms needing to comply with the upcoming Phase 6 deadline for UMR, compared to other firms who have met their UMR requirements (Phases 5 and 4, for instance)?
Sigurjonsson: We are finding that many of the firms, including asset owners, who need to comply with UMR ahead of the Phase 6 deadline this year will outsource the management of their derivatives. Many of these asset owners have potentially never had to post IM before and do not want to start dealing with it now, so they are looking to stay below the IM threshold figure of USD 50 million per counterparty. This threshold figure may be significant for many of these asset owners considering how much they trade currently. However, if a firm would split that figure equally among five asset managers, for example, each must remain under USD 10 million, which leaves them little room for error. Pre-trade capabilities to check margin implications before a trade is executed can be very valuable for Phase 6 firms that need to actively manage their margin to ensure they do not accidentally cross over that threshold.
Firms looking to deploy these sorts of capabilities ahead of the September deadline need to get started now to ensure enough time for legal contracting, which can take months, and a testing period, which should begin in the spring or early summer.
Knaap: Many Phase 6 firms believe they will never cross the threshold but cross-examination of trading activities with counterparties could reveal how difficult keeping under the threshold may be. Ultimately, it is crucial that firms know their numbers in real time and continues to monitor this on a pre-trade basis to reduce the risk of that portfolio breaching the threshold. Breaching the threshold, with no operations in place to ensure compliance under UMR, requires halting trading, which can also mean unwinding of a position or positions and thus incurs other risks and challenges. A Phase 6 firm that uses pre-trade analysis and threshold monitoring effectively can be very successful in staying under the threshold across all trading activities.
Q: What about firms in the former states of UMR—what is driving these firms to switch to pre-trade margin analytics at this stage?
Sigurjonsson: Pre-trade analysis is also important for Phases 3, 4 and 5 firms where they are within UMR’s scope but need the infrastructure to manage their margin movements effectively and the possible impact on their P&L.
Looking at each group in turn, many Phase 5 firms were initially focused on ticking the regulatory box and making sure they were complying, but they have since realised that the volume of margin movement activity is high and managing the costs and thresholds is challenging. For these firms, pre-trade analytics is not simply a tool for compliance but also essential for the reduction of collateral costs which is a key competitive advantage for them now and in the future.
The same competitive driver applies to Phase 4 firms which are in a highly competitive environment where every basis point matters. For these firms, if they fall behind their competitors in optimisation and analytics, they will be losing basis points that will affect their performance and thus their competitive edge.
Knaap: I would add that a key difference in the use of pre-trade margin analytics for firms within the Phases 3 to 5 is whether they outsource or not. Firms that outsource collateral management or parts of the collateral process, may not have the in-house infrastructure, or easy access to their data, to plug into the pre-trade order flow so will rely on their outsource provider/administrator to offer these tools including ‘what if’ scenario trading analysis, for instance. The end goal of margin analytics and optimisation will be the same across firms but there will be operational differences in terms of how this is conducted depending on their setup.
Q: For firms looking to take margin optimisation one step further, what can they start doing now with the aid of technology and sophisticated pre-trade analytical tools?
Sigurjonsson: UMR was put in place, in part, to incentivise central clearing for counterparty and systemic risk management purposes. Thus, bilateral derivatives trading may be more expensive, but it is not as simple saying that it is always cheaper to clear. Analysis of the method of trading – bilateral or centrally cleared – is the next step for margin optimisation for many firms. With the use of pre-trade analytical tools, firms can better identify when it is more cost effective on all levels to clear or trade bilaterally for specific trading activities. And if firms do centrally clear a trade, it can help them decide which Futures Commission Merchant (FCM) to use in order to minimise their margin requirements for that transaction and optimise funding costs overall.
Following this, a natural next step would be to expand that pre-trade capability to OTC cleared and exchange-traded derivatives (ETD). With analysis, firms could strategise their trading activities – bilaterally versus clearing, how many FCMs they are using, and where they place each of their trades. In doing this analysis, a firm would gain an ability to avoid any sort of liquidity or concentration add-ons and minimise the margin requirement across their whole derivative book.
Knaap: This analysis also extends to looking at all asset classes across the entire portfolio. Firstly, any product – repo, securities lending, etc – that incurs IM or an Independent Amount (IA), could and should be pulled together so a firm can then optimise margin efficiently across the board. Once this holistic view is obtained, firms can start looking at their trading arrangements and optimise across brokers, and for the cleared and uncleared flows take advantage of other tactics, such as novation to further achieve margin efficiencies and reduce costs.
For example, the addition of an additional clearing broker (FCM) might help a firm minimise, or even eliminate, the incurrence of a CCP liquidity-add-on, which can add up to 50 percent to the margin in certain cases. This change alone, as identified in the pre-trade analysis, could possibly reduce the margin by a third, which is hugely significant. Firms can then start looking at reducing and optimising collateral drag caused by satisfying the IM.
We are seeing a growing number of firms looking to rebalance their margin weekly using these analytical and optimisation tools. By continuously optimising margin across the trading activities, firms can keep both their margin numbers low and stay under the threshold. This pre-trade analysis is essential in monitoring their activities to stay under the UMR threshold.
Q: What next? Where do we go from here?
Sigurjonsson: If you think about a holistic optimisation framework, margin optimisation and pre-trade is a big part of that, but it is not the end of the road. Once pre-trade is in place, there are also post-trade capabilities on the margin side, and things like porting between FCMs, CCP switches—innovations that can really help firms maintain optimal position post-trade. Finally, the ability to access cash and other eligible collateral needs to be considered. Regulations are not just hitting the buy side; they are also making banks’ balance sheets more expensive. Those costs are passed on to clients through pricing making traditional ways of doing repo more expensive for buy-side firms. Alternative liquidity sources such as clearing and peer-to-peer solutions may provide a cost benefit for buy-side firms. Ultimately, firms need to have a broad set of tools available to them to minimise funding costs.
Knaap: The opportunities and benefits of pre-trade analysis and margin optimisation are clear but what we have outlined here is just the beginning of the holistic framework that the industry is moving towards. Following the optimisation of margin for UMR, cleared derivatives, and ETDs, the next steps include analysis of the best collateral to be used. When you have margin and collateral optimisation under control, the next step is to forecast and stress test Variation Margin (VM) & IM as well as Credit Support Annexes (CSAs) and the collateral asset themselves to achieve collateral resilience. Firms need to know their funding requirements for at least the next trading week in the worst-case scenarios. It also allows firms to drive alpha from their remaining inventory which will improve the P&L of their funds. If a firm, for example, can reduce its collateral buffers through margin efficiencies gained from optimisation and tighter margin management, this frees up the collateral inventory to be used in securities lending and repo activities to generate alpha. This is the place all firms want to get in time.
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