The focus within the collateral management space has shifted from regulatory compliance to better controlling how margin might impact trading decisions and the overall business. In a DerivSource commentary, Cassini Systems’ CEO and founder, Liam Huxley explains how firms can achieve greater collateral resiliency using analytical and optimisation tools to better equip their organisation’s defences against trading, operational and liquidity risks that could impact their bottom line.
Converging market and regulatory macro trends mean that asset management firms need to bolster their collateral resiliency to ensure they can meet their collateral demands in all situations, in a cost-effective manner, and without causing disruption to trading strategies.
Regulations put in place following the global financial crisis of 2007-2008 sought to address systemic risk by requiring the collateralisation of all bilateral trades. Compliance with these regulations involved a lot of legal work (papering new agreements for different counterparties, and ensuring firms had all the right terms and protections in place), as well as new technical workflows to be able to message the right custodians and institutions, for example. Now that initial work is largely done, and so firms focus is shifting to managing capital efficiency, as demand for collateral and cash is rapidly building up. In a benign market, this might be less of a concern, because funds would post out cash or be able to meet collateral day-to-day quite easily.
Volatility and inflation strain collateral capabilities
However, extreme volatility and market events have become much more common in the last two years. Some of the volatility spikes have led to initial margin (IM) increasing by more than two times in a matter of days, and in one extreme example, given by Cassini when discussing how their client have been impacted by the onslaught of market volatility, a client has seen a six times increase in margin over a period of 2-3 months.
Variation margin (VM) is also seeing large swings in terms of day-to-day mark-to-market (MTM) moves . Many funds suddenly had to find large amounts of additional collateral at very short notice to stay within the bounds of their agreements and the regulations. At the peak of Covid-related volatility in 2020, for example, some firms had to liquidate large sums of cash to respond to margin calls and were forced to exit their strategies at the worst possible time. Going forward, it is important that portfolio managers (PMs) are not forced to abandon trades because of collateral concerns.
More recently, the markets have seen interest rates, inflation and the cost of money accelerating very rapidly. Shockingly, the UK’s conservative and stable pension funds industry had to be bailed out by the Bank of England, as a result of unusually large market movements generating significant margin calls.
Collateral cost and volatility now pose a material risk and P&L impact to any asset manager. Controlling collateral—by implementing a collateral resilience operational model -—should be embedded in a buy-side firm’s trade control process from front to back in the same way as market or credit risk. In short, a Collateral resilience operational model will ensure there is always sufficient collateral to meet any demand in any market.
The three sets of tools Cassini recommends are margin optimisation, collateral optimisation and forecasting & stress testing. Ideally, firms would deploy all three across the trade lifecycle.
The 3 pillars of a collateral resilience operational model
Collateral resiliency is about reducing cost to the business, freeing up cash and assets, and ensuring sufficient liquidity for volatile conditions. There are 3 pillars that define the tools needed to implement this model.
Margin optimisation tools help firms understand which trades or strategies are driving margin requirements, and which are more capital intensive, and then make decisions on best execution and the capital impact of new trades. This can sometimes extend to identifying alternative asset types that have same risk profile but lower margin impact.
Rebalancing exposure between counterparties or clearinghouses may achieve the best risk offset. Traders often execute without considering the post-trade impact and the cost, so firms end up with inefficiently distributed portfolios between bilateral and cleared, and between clearing brokers and clearing houses. Putting positions and risk exposures in a more efficient place—changing the counterparty exposure rather than the trading book exposure—can deliver some quick wins for firms looking to rebalance their portfolios and optimise margin. In one case study, a Cassini client was able to optimise its margin strategy by 47%.
However, when a PM closes out a trade or a strategy to reduce an identified risk, they also need to know if that trade was providing an offset to a different trade. If so, then unwinding that trade could unwittingly increase the margin requirement. Unwind risk reporting shows PMs those potential issues and allows them to plan the funding liquidity needed to cover it.
Collateral optimisation tools enable firms to consider the true opportunity cost for every asset in their inventory. On a daily basis, firms can mathematically find the most optimal, cost-efficient collateral to send out for any new margin requirements.
Additionally, they can run weekly rebalancing processes to perform substitutions and reallocate across counterparts. These two analytics sets help firms minimise the potential margin demand and figure out the cheapest possible collateral to send out and keep liquidity.
The third set of tools involve forecasting & stress testing and should align with market risk scenarios. A firm might want to understand its overall portfolio risk exposure in a situation where interest rates go up by a particular amount, or a country defaults on its debt, for example. Every fund has these risk scenarios as part of their market risk management and the same scenarios should be applied to margin collateral risk. They can then combine that with forecasting around potential changes in positioning of the portfolio or overall growth. This shows what the potential demand for collateral will be in those different scenarios and allows funds to look at their liquidity and see whether they can meet those or if not, put in place the right funding tools.
All three tools collectively support a firm’s ability to establish collateral resiliency across their organisation and operations.
Using collateral analytics to generate alpha
Once firms understand their collateral demands, they can then look at what portion of their inventory is unencumbered and will not be required to meet collateral liquidity under their forecasts & stress test scenarios. Firms can then consider using higher friction investment tools, where they may not be able to free up the asset for two or more days, which generate higher returns, confident that they will not require that asset as collateral liquidity.
For example, firms can consider term repo instead of overnight repo which has a higher return, because they will not need to call on that asset out of the blue.
Some firms have conservative mandates and the treasury team are only responsible for managing collateral liquidity and do not look for alpha opportunities. This is based on a risk view where there is no certainty on future margin demands. Implementing a robust collateral resiliency model provides this comfort and allows treasury teams to guarantee to the firm’s C Suite that it can cover any collateral situation the traders want to get into based on the current trading profile and forecast.
They can then extend the liquidity and collateral optimisation models to identify the best way to allocate surplus inventory and to optimise for maximum return.
Advice to firms—don’t wait!
Increased collateral demands, heightened volatility and recent higher cost of cash represent a perfect storm of different macro trends that lead to real operational risk to asset managers. Managing their collateral resiliency will help firms weather the shocks and can even lead to new opportunities for generating returns. It’s a win/win.