There are various capital efficiency solutions available now to support the increasingly stringent collateral quality and quantity required to meet margin requirements for cleared and uncleared OTC derivatives. Daniela Schroeder of Commerzbank explains how cross margining works and explores if it is really the panacea to margin efficiency it is hyped up to be.
Q. As Commerzbank is a clearing broker and post-trade service provider, can you tell us a little bit about what you believe cross margining to be and how it works operationally?
A. Cross margining is not a new concept, however, the margin efficiencies this service delivers is needed now more than ever as a result of new regulation, including the European Markets Infrastructure Regulation (EMIR), that imposes strict frameworks for how both cleared and uncleared Over-the-Counter (OTC) derivatives are collateralised. Financial institutions of all types including end users and buy-side firms, in addition to larger market players must consider how to reduce the collateral burden in light of the expected increases in margin required for cleared and uncleared derivatives trades. Some derivatives market participants may be able to take advantage of cross margining to offset trades and positions across trade flows to reduce the total margin required to meet collateral obligations which in turn reduces the cost of funding and other related collateral management costs.
However, cross margining doesn’t suit every type of institution and there are obvious prerequisites for eligibility to be able to use this tool. Firstly, a firm should have the same clearing broker for both cleared and exchange-traded derivatives (ETD) workflow, which is not necessarily common practice today. Traditionally, the ETD and OTC derivatives businesses have been siloed, often housed with different clearing brokers and each with its own liquidity pool. Cross margining is ideally suited to firms who use a single clearing broker manages both ETD and OTC cleared accounts and can establish a joint Means Fixed Income (MFI) liquidity pool to offset trades or positions for both streams to reduce the total number of margin calls.
Q. Who is best suited to use cross margining? What are the benefits?
A. It is important that financial institutions first assess their portfolio’s eligibility for cross margining. Clearing brokers, such as Commerzbank, can provide this portfolio analysis but also determine the benefits a client will achieve through cross margining.
Specifically, financial institutions really need to have a certain size and type of portfolio, both ETD and OTC cleared flow for instance, to be able to offset trades and to gain the efficiencies cross margining can offer. Some clients may have one-sided ETD books and one-sided OTC books and there may not be offsetting between the two.
If a firm is eager to employ a margin reduction strategy we suggest they consider two changes if applicable: change the current investment strategy from just ETD or just OTC to a combined strategy, and review combined strategy to ensure there are offsetting positions. Essentially the ETD and OTC positions need to have the same risk profile and are offsetting, otherwise no cross product margining can be used.
Cross margining is not a one size fits all solution, but if the client has the possibility to change the strategy, it can lead to great reduction of margin required which greatly impacts the firm’s funding costs and liquidity management.
Q. Do you ever get questions from potential clients who ask if there are alternative ways to get capital efficiency such as other collateral optimisation methods?
A. Yes, definitely we get those questions from our clients however, for most, it’s not one method or the other but often both. For example, a client may use cross margining services for OTC cleared and ETD trade flow but would also seek to further reduce the collateral requirements for their bilaterally traded derivatives contracts too.
For bilaterally traded derivatives or traditional OTC derivatives contracts, many banks and financial institutions may already have netting agreements in place via their Credit Support Annex (CSAs) and firms are increasingly reviewing these agreements to ensure they are up to date. After a review of our own CSAs for instance, Commerzbank updated its own agreements with the intention of reducing collateral requirements within the bilateral business.
Commerzbank is now offering this CSA review as a service to clients looking to leverage our experience in updating these agreements to achieve greater margin efficiencies for bilateral flow too. Commerzbank also offers collateral optimisation, determining the cheapest to deliver collateral for cleared of bi-lateral flow. With cross margining, combined with the recently negotiated netting agreements and details via the CSAs for bilateral flow & optimisation, firms will have ticked all boxes to ensure their total margin obligations is reduced and their cost of funding will hopefully be more manageable now and in the future.
In this new environment, firms that do not actively manage collateral run the risk of posting more than they have to, liquidating unnecessarily to cover margin calls, diminishing their trading capacity, and missing opportunities for incremental profit. With a more complex market structure and stricter rules, paying closer attention to margin requirements is clearly in a firm’s best interest.
In addition to the review of CSAs, netting, optimisation and cross-margining solutions, for some firms it makes sense to outsource the collateral management itself. This is especially true for smaller institutions for which it would be difficult to handle all these new requirements with the existing team and resources.
To support clients eager to outsource collateral management, Commerzbank has teamed up with Clearstream to offer a joint offering called TradeCycle. In this new joint offering Commerzbank provides firms with client clearing and collateral advisory services, such as the CSA review and update service I mentioned already, and Clearstream provides the post-trade collateral management support.
Many financial institutions, particularly end users, regional banks and buy-side firms, do not have the infrastructure or resources available to support the change from weekly or monthly margin calls to daily as required going forward so outsourcing this function makes sense. And TradeCycle supports the collateral management needs for both cleared and bilateral derivatives trade flow so clients can consolidate with a single provider.
Q. What are the challenges cross margining poses to both the provider of the service and also to your clients or the users?
A. Cross margining itself isn’t complicated but the operational and legal set up requires initial investment and attention. With the legal set up, reliance upon market standards for legal contracts can be beneficial and help streamline the set up. For instance, if you have the market standard documentation you can add or adjust an annex rather than negotiating the whole contract from scratch again.
As mentioned previously, both the ETD and OTC flow needs to be centralised to the same broker to facilitate the cross margining services. There are advantages to using the same clearing broker for both ETD and OTC business lines because it is simple to add on a trade flow of an additional business line if a firm has an existing relationship and connection with a broker. It’s a single point of entry to two markets.
From a clearing broker’s perspective, our first challenge is to ensure we are connected to the central counterparties (CCPs), which also supports cross margining and setting up this connectivity requires investment.
It may be easier if the CCP is all under a single framework because if a clearing house does operate several entities this can impede cross margining as there are different jurisdictions to contend with. So, if you have a CCP that’s in one location and can offer cross margining via various products it should be easier to achieve efficiencies.
Also, the product coverage by the CCP is a major factor. With clearing houses offering high market liquidity it’s easier for clients and clearing brokers to use that CCP and therefore also gain traction on it. Further margin efficiencies can of course be gained with as both the volume of trades and the number of counterparties dealt with through a single clearing house grows
In addition to establishing and managing CCP connectivity, the clearing broker must be able to send the margin calls to the clients, who requires reconciliation of all margin calls from the CCP with its own margin calculations and then reconcile separate calls for the clients including those using cross-margining services. This process is necessary to ensure the client gets the exact number, and it’s probably easier if the provider uses one single collateral system to support this process.
At Commerzbank we originally had two collateral systems but transitioned to one system after investment to allow us to easily reconcile the margin calls that are coming and the margin calls that we need to send out to our clients.
The collateral management system is only one factor; with such high volume of margin calls you need a dedicated team and resources. Developing both the system and team is ongoing.
For the end users, the challenge for them is to have the connection to the clearing broker for both ETD and cleared OTC workflow. Luckily this process is not too onerous because the clearing broker guides the entire onboarding process. In our case, for example, from the OTC side we were able to do an onboarding with the client in five weeks, which was our fastest onboarding so far. So quick and easy onboarding is possible! Of course a client needs to have the right infrastructure in place, such as use of a confirmation platform, so the connection can be quickly established and tested.
Q. Are there ways to improve the speed or efficiency of the onboarding process?
A.Yes, having a dedicated onboarding team and resources to manage the process is essential but also ensuring the process is well managed and straight forward will allow clients to be aware of the milestones in the process and will help them monitor progress and their own involvement better.
Q. What would be a competitive advantage from one cross margining service compared to another?
A. The competitive advantages for Commerzbank compared to other clearing brokers are that we have a straightforward onboarding process. Even if the client is a counterparty for us in a single product, we can onboard that firm quickly so the full clearing services including cross margining is readily available.
It’s important to note that also we are the first European clearing member to offer cross margining which clearly shows we have invested in our margin efficiency early on and are dedicated to our derivatives clearing business. Of course there will be others who offer this as well but our existing and new clients will rest easy knowing they will be supported by dedicated teams and newly invested resources.
Q. What about timing? Do you expect most non-clearing members or clients to utilise such a cross margining service immediately?
A. That’s a good question because it depends on so many things including: the make up of the existing portfolio, whether or not the firm wants to change their trading strategy and the clearing obligation itself. We see that clients have started CCP clearing for some standardised derivatives but the current volume of clearing is not yet at the level it is expected to be once the clearing obligation is already in place. Depending on the final regulatory standards the clearing volume could increase before the clearing obligation comes into force, as the frontloading requirement is still in discussions.
