MARGIN OPTIMISATION: A KEY DIFFERENTIATOR FOR FIRMS OF ANY SIZE.
Jo Burnham, risk and margining expert at OpenGamma
Margin is something that larger firms are already familiar with. But by the time UMR (Uncleared Margin Rules) Phase V is introduced in September 2020 there will be over 9,000 additional entities in scope to post margin. This will result in a lot more margin being exchanged, and consequently a liquidity squeeze on suitable collateral to cover this margin.
Therefore, margin optimisation – minimising the amount of margin paid – becomes an important requirement not just for a few firms, but for the majority. The lower the margin the less collateral required and, therefore, the less you will be impacted by costs associated with in-demand collateral. And even if you are lucky enough to have access to sufficient collateral, by optimising your margin requirement you will be maximising your return on capital. Whichever way you look at it – margin optimisation is key to increasing capital efficiency.
So that leads to the question ‘How do I optimise my margin?’. The answer depends on the type of firm you are and the products you trade. But there are four key areas to consider:
- Multiple clearing brokers
- Multiple clearing houses
- Bilateral to Bilateral
- Bilateral to Cleared
Let’s look at each of these in more detail.
Multiple Clearing Brokers
If you are clearing your business through clearing brokers then you need to make sure that you are making best use of them. By careful allocation of your business between your brokers you can make significant savings on the margin required.
Most CCP algorithms allow offsets between different products. For any algorithm that is based on VaR (Value at Risk) you will naturally get offsets between profits and losses, for example, between different currencies for swaps. And, for scenario-based algorithms like SPAN, then explicit offsets will be allowed between correlated products. You need to make sure that you are correctly allocating positions between brokers to make the most of these offsets.
You also need to consider the liquidity and concentration add-ons included in CCP algorithms. This means that the larger the position the more margin you will pay. Brokers require margin based on the CCP algorithm, so if you split your position between multiple brokers you will have a smaller position at each and therefore significantly lower margin add-ons.
For a large number of centrally cleared products, there is a choice available of where to clear your position. Traders generally take into account any pricing basis between the CCPs and differences in liquidity, but it can also be worth considering the level of margin charged.
Although CCPs are subject to similar regulation in terms of the risk coverage their margin algorithms should provide, there can be surprising differences in the number calculated based on the same portfolio. The collateral that can be used to cover this margin – and the haircuts applied to the collateral – also vary between the CCPs. A CCP that accepts a wider range of collateral may well be worth considering with the inevitable liquidity squeeze on collateral that will result from the introduction of UMR Phase V.
And not to forget cross margin. CCPs that offer clearing of OTC swaps, as well as ETD fixed income products, generally allow margin savings based on offsets between the two product sets. This margin saving should be considered when deciding on where to clear.
Bilateral to Bilateral
UMR creates its own optimisation opportunities. In particular, firms can agree to a regulatory threshold with their counterparties that they would need to reach before posting or receiving margin. So when deciding who to trade with you should make sure that you are making full use of any available thresholds in order to minimise your margin costs. The calculation of margin has a ‘best execution’ impact: an opportunity to optimise your return on capital. Especially when the thresholds can cover your margin for free.
Bilateral to Cleared
Only some products are subject to a clearing obligation. For others – where a CCP offers the service – you have a choice of whether you clear the position or remain bilateral. In terms of margin, the most obvious thing to look at is the difference between the margin required by the CCP and the equivalent margin calculated using SIMM – the method most likely to be used for bilateral margin.
And if you think that remaining bilateral is best, then it might be worth considering the cost of calculating and reconciling SIMM (Standard Initial Margin Model) margin. Unlike the CCP algorithms which take trade details as their input, SIMM requires each counterparty to calculate sensitivities for the bilateral portfolio. The margin is then calculated based on these sensitivities and reconciled between the two counterparties. Here, even a small difference in the sensitivity calculated – for example, by the use of a different option pricing model – can have a significant impact on the margin calculated. This additional operational cost should probably be built in to the execution cost to make sure that you are getting the best return on your capital.
To sum up
It’s a challenging time from a margin perspective, especially with the approaching introduction of UMR Phase V, but from challenges come opportunities. By aiming to optimise your margin, there is an opportunity to differentiate yourself from the rest of the pack. The increase in margin requirements and the subsequent collateral liquidity squeeze is going to make it harder to achieve capital efficiency, so adopt a proactive view to address this and protect your bottom line.
©Best Execution 2019