Lynn Strongin Dodds looks at attempts in the derivatives industry to improve capital and margin optimisation in a rising cost environment
Capital and margin optimisation are once again at the forefront in the derivatives world due to the escalating cost of capital and the regulatory push toward central clearing, according to a new report – The Portfolio Margining Imperative for Interest-Rate Derivatives – from Coalition Greenwich.
The report, which is based on an analysis of industry data on margin pools and interviews with US and UK market participants, found great strides have been made via compression efforts, collateral selection algorithms and improved pre- and post-trade analytics. However, the largest opportunity for margin optimisation remains largely untapped.
This is mainly due to the inefficiencies with margin offsets. It is well documented that margin requirements can be safely reduced when counterbalancing positions within a firm’s portfolio are held at the same clearinghouse. However, this is still not the case when they are sitting in different central clearing counterparties (CCPs).
Take two highly correlated products – US dollar interest-rate futures and interest-rate swaps. The CME clears nearly all US Treasury (UST) futures and Secured Overnight Financing Rate (SOFR) futures trades while London Stock Exchange Group’s clearing arm LCH is responsible for nearly all US dollar (USD) interest-rate swaps trades. The study estimates potential margin savings of up to 80%,if they were cleared under one roof.
As Stephen Bruel, senior analyst at Coalition Greenwich Market Structure & Technology and author of the report notes, netting of futures and swaps risk in a single clearinghouse would also reduce the potential for market participants being caught out due to margin increases from volatility spikes. “Not only would individual trading entities benefit, but the financial system would see an improvement in risk efficiency,” he added.
In the past, the status quo may have been acceptable but as the report points out, higher capital charges under regulation such as Basel III have squeezed margins, compelling derivatives players to be more strategic about how they optimise their margin obligations. This has not only made them rethink where they trade but also how and where they clear the instruments, Bruel said. In fact, banks polled in the report confirm that “capital efficiency through netting and margin optimisation” has become an important criterion in their assessment of their relationships with CCPs.
Given the issues, it is not surprising that attention has centred on opening the doors wider for portfolio margining which currently has limited bandwidth. In a nutshell, the product assesses an entire portfolio of futures and interest-rate swaps held at a CCP, nets those positions where appropriate and then calculates a new margin requirement. This can result in in a lower obligation. In fact, the report argues boosting the activity at scale between offsetting US rate futures and USD as well as non-USD swaps would free up significant capital for other uses.
Both sides of this equation are working to attract the other’s open interest, but progress has been slow. For example, ten years ago, CME launched client clearing of USD interest-rate swaps to support clearing mandates, but uptake was limited for USD swaps. This is not surprising given that LCH’s SwapClear has an almost 98% lock on the business.
BGC Group is hoping to make headway with its newly launched FMX Futures Exchange. Currently, the new exchange enables clients to trade Secured Overnight Financing Rate (SOFR) futures with the UST version to be added in the first quarter of 2025. It hopes market participants will reap “significant capital savings” through its partnership with LCH which handles more than $162trn of US dollar swaps.
The Coalition Greenwich report says the move is the latest salvo in the clearing battle which has been going on since Dodd Frank was enacted. If FMX or any new bourse wants to succeed, it will need to “build an ecosystem of banks, market makers and clearing brokers to ensure that clients can access liquidity and seamlessly process and margin trades.” FMX’s 10 current partners include the largest banks and market makers, and seven of the eight largest futures commission merchants (FCMs). However, given CME’s current market share as sole incumbent in U.S. rate futures, differentiation in margin efficiency becomes paramount for FMX or anyone hoping to be a meaningful rival.
