Uncleared Margin Rules and the Rise of Initial Margin Optimization
As the countdown to the final phases of the uncleared margin rules (UMR) are upon us, buy-side firms that will fall into scope have been cast into the spotlight. While earlier phases of the rules haven’t created much of a stir beyond complaints linked to increased costs, the many buy-side institutions that will be required to post and receive margin in relation to their bilaterally risk-managed books for the first time have raised a few eyebrows. In a recent report, Uncleared Margin Rules and the Rise of Initial Margin Optimization, Aite Group senior analyst Audrey Blater discusses an array of solutions offered to both the buy-side and sell-side to combat rising margin fees.
UMR Has Pushed Margin Efficiency to the Forefront
The onset of the UMR has created an industry need for better management of initial margin (IM). Traditionally, portfolio compression providers have addressed capital costs borne by the sell-side in relation to their derivatives portfolios. In a space that was once dominated by a single provider, TriOptima, competition and innovation from the likes of Capitalab, a division of BGC Brokers L.P., CME Group Inc., LMRKTS, and Quantile Technologies Limited have led to a breakup of the monopoly and the expansion of solutions. Now, IM optimization tools and analytics have effectively become the bigger story.
The various portfolio compression and optimization providers focus on different asset classes. As the table shows, TriOptima’s triReduce portfolio compression solutions span the greatest number of asset classes (black circles). However, Capitalab and Quantile Technologies compete with TriOptima in the compression of rates products. Capitalab is more niche in the sense that in addition to compressing IRS, the company is able to compress bilaterally risk-managed swaptions, caps and floors, and FX options as well as optimize linear and nonlinear products in the same run.
UMR has given rise to IM optimization, which initially grew out of the rates asset class (white circles). Capitalab, Quantile Technologies, and TriOptima have solutions that span rates, FX, and even equity derivatives. LMRKTS focuses solely on the FX asset class. Lastly, the need for capital efficiency (black squares) has also played a role. For example, CME Group’s FX Link allows market participants to move from an OTC FX spot position to a listed FX futures position using a single spread, lowering capital fees. Arguably, all compression solutions address the need for better capital management.
Don’t Fear It, Clear It
While portfolio compression allows sell-side shops to net down offsetting risk and reduce charges, the buy-side has turned to clearing as a method to lessen the blow or even avoid the UMR. Although there is no direct clearing mandate for FX, the push of the UMR has made clearing of FX instruments one avenue institutions have recently taken to keep themselves out of scope.
LCH clears about 95% of the FX nondeliverable forward (NDF) market. LCH’s ForexClear reported a quadrupling of NDF clearing in 2017 followed by 55% growth in 2018. It makes sense that volume would edge higher. However, not every instrument can be cleared. As the figure shows, during 2018 there were effectively no barrier options, swaptions, exotics, and cross-currency swaps being cleared. The majority of NDFs also sat outside the clearinghouse.
When Avoidance Isn’t the Answer
Assuming buy-side firms can’t clear their positions or choose not to, institutions will be looking for ways they can optimize their IM once the UMR compliance-day dust has settled. In the swaps world, buy-side firms have used compaction, which is essentially an electronically traded “package” designed to either reduce line items at the clearinghouse or tweak risk in the process, to simplify their books and reduce cost. Bloomberg and Tradeweb operate swap execution facilities (SEFs) in the dealer-to-client space and offer compaction as well as electronic trading capabilities.
Looking beyond cleared interest rate derivatives, buy-side traders and portfolio managers may turn to third-party providers for help in the optimization of IM to reduce cost. While the sell-side is chock full of vendors offering margin efficiency tools that even reach into the dark corners of derivatives products, such as swaptions and FX options, the buy-side has fewer options to choose from today. Although it’s not far-fetched to envision a day when sell-side providers expand their offerings to the buy-side, a handful of firms are already dedicated to this client base.
Cassini Systems offers IM optimization functionality for both cleared and noncleared OTC derivatives as well as exchange-traded derivatives. The firm provides pre-trade IM optimization tools to measure the immediate economic impact of a potential trade. Clients are able to perform ISDA standard initial margin model (SIMM) calculations on existing portfolios to better understand how much cash might be tied up for collateral. The company sets itself apart by completing its offering over the life cycle of a trade through tools and analytics that can calculate intraday margin attribution, rebalance portfolios, and perform unilateral compression to improve margin efficiency.
OpenGamma’s algorithms recommend trade ports or new risk to minimize margin across brokers, strategies, and portfolios between brokers or major central counterparties (CCPs). The cloud-based service allows managers to conduct what-if analyses for portfolio managers who are sensitive to increases in margin as a result of unencumbered cash limits or Treasury who want to minimize margin consumption. OpenGamma’s platform allows firms to attribute OTC exchange-traded derivatives and bilateral initial margin to strategies and portfolio managers. Among their clientele, OpenGamma provides solutions to banks, asset managers, hedge funds, pensions, and other firms.
What Should the Buy-side Expect?
The issue of margin optimization for buy-side firms stems from the variety of CCPs where they may clear trades down to sell-side counterparties and the level where individual portfolio managers are consuming margin allocated across funds and strategies. Given the prevalence of more sophisticated portfolios, buy-side firms will need broader solutions to address IM optimization. For example, portfolios likely consist of both cleared and non-cleared positions, domestic and international holdings, and investment in multiple asset classes in various liquidity pools. The result is a more complex optimization problem, and the buy-side should expect more complex and competent solutions developed by existing providers as well as solutions from new entrants continuing to enter the space. Stay tuned.
Find Out More
The full report on UMR and IM Optimisation is available here: https://www.aitegroup.com/report/uncleared-margin-rules-and-rise-initial...