Liam Huxley, CEO of Cassini Systems, examines volatility and trading risk in derivatives markets and the importance of putting post-trade management at the core of the trade control process
The volatility we have seen across derivative markets in recent years has presented many challenges to portfolio and risk managers, but one area that has become more significant in recent volatile periods has been the swings in margin requirements to support derivative portfolios. This impact has been across the board, but has been recently highlighted in areas such as commodities and emerging markets. In addition, increasing regulation — and specifically the rollout of the Uncleared Margin Rules (UMR) — has broadened the amount of the portfolio that has to be collateralised, which has created even more stress on collateral demands and on meeting counterparty obligations.
We have seen many examples in recent times where outsized swings in margin requirements have forced firms to unwind positions or, in some cases, to suffer more severe consequences, with some firms being forced to cease trading altogether. Recent cases that spring to mind include an energy firm whose margin has gone up by 600 per cent, and a wealth manager that had to unwind US$400 million of positions in the volatile markets of 2020.
Having to back out of trading positions, or to take losses because of collateral liquidity issues, is the last thing any risk manager should countenance.
We are therefore seeing many firms kick off initiatives to strengthen their collateral processes and transparency, as well as more awareness of the need for collateral resilience as a key control point in the trade control matrix.
What is collateral resilience?
So, what does this really mean? In essence, collateral resilience is an operating model that ensures there is sufficient collateral available to cover all trading demands and, specifically, the unexpected impact of volatile markets.
This means putting post-trade management at the core of the trade control process, alongside compliance, market risk, and credit risk management, and implementing tools to track collateral impact from pre-trade through the lifecycle until closeout.
Given the siloed nature of technology and data in many firms, the exact implementation of a collateral resilience programme will vary, but it should include the following core pillars:
Pillar 1 – Margin optimisation
By using tools such as pre-trade margin checks, or post-trade rebalancing, it is often possible to reduce the margin requirement across the portfolio. Doing so reduces the ultimate need for collateral and is, therefore, a key foundation of the whole resilience model.
Pillar 2 – Collateral optimisation
A robust collateral optimisation model will reflect the true value of collateral inventory to the firm, including trading demands and funding costs. Mathematical optimisation can then be applied to ensure that the largest possible amount of high-quality liquid asset (HQLA) is retained in the unencumbered pool to allow flexibility when shocks arrive.
Pillar 3 – Forecasting and stress testing
As with market risk and any other risk control model, it is important to project future potential impacts and, therefore, stress test your books against high-risk scenarios. For collateral resilience, this involves stressing trade and margin levels, collateral values, as well as legal terms with counterparts such as eligibility schedules.
Challenges
Of course, none of this is easy to implement and there are common challenges that many firms encounter. These include:
• Understanding inventory availability and collateral mobility across the firm. Too often firms default to posting cash, or maybe US Treasuries, when they are holding other eligible assets or could easily source alternative collateral assets.
• Integration across business lines. Collateral resilience requires a firm-wide solution that ensures all obligations are met and all sources are utilised. Bilateral, cleared, exchange-traded derivatives (ETD), and prime brokerage (PB) portfolios are often segregated at both business and technology levels and harmonising across these boundaries has many obstacles.
• Changing business workflows to implement dynamic intraday or pre-trade controls is not simple, as it requires changes to both order staging and execution systems.
• Implementing post-trade optimisation and forecasting requires support for a multitude of counterparty risk and margin models.
• With collateral held at multiple, internal, and external sources, firms may struggle to create an all-inclusive, real-time view of their collateral.
Summary
Initial margin (IM) has become the ‘topic de jour’ because of new regulations and recent extreme global events, but the increasing demand for collateral means that investment managers of all styles must focus on more than just their daily regulatory and operational compliance. They must also ensure that the collateral function can guarantee the ability to support derivatives trading in all market conditions, which includes the technology and the systems you use.
Collateral risk is a real risk and should be controlled and monitored with a focus equivalent to market and credit risk. This requires a strategic approach with integration across business lines and technology silos, and novel tools that allow for sophisticated control and transparency.
