Varqa Abyaneh, chief product officer, Quantile Technologies
(Editor’s Note: In this guest post for the Bull Run, Varqa Abyaneh, chief product officer from Quantile Technologies Ltd. focuses on industry participants grappling with the costs of funding multiple margin requirements globally.)
Designed to improve the safety and stability of markets, regulation inevitably increases the cost of trading. Participants are still expected to deliver healthy returns while keeping pace with the evolving regulatory obligations and, to thrive, must carefully manage their resources.
Ensuring banks meet their minimal capital requirements is no longer the only focus, and the trend transforming regulatory capital into funding requirements looks set to stay.
The Funding Challenge
One of the main resource-consuming issues is the cost of funding the margin requirements globally. Without careful management, the requirements can consume critical financial resources and have an adverse effect on the returns of the derivatives book, as well as the pricing and liquidity of the underlying derivatives trades if left unchecked.
From the uncleared margin rules (UMR) to the greater use of central clearing, Quantile investigates the trends and requirements, their impact on the margin landscape, and provides solutions as to how participants can proactively optimise their portfolios to avoid higher costs and minimise the funding drag.
The Requirements & Current State of Play
Since 2016, participants trading non-centrally cleared derivatives including FX [foreign exchange] options, NDFs [non-deliverable forwards], swaptions, and hedging trades have been subject to new margin requirements.
Initial margin (IM) is one of two types of collateral required to protect participants in the event a counterparty default.
The other type of collateral — variation margin (VM) — is paid daily from one side of the trade portfolio to the other, to reflect the current market value of all trades in the portfolio.
IM, however, is held to cover the losses that could arise in the period between the defaulter’s last VM payment and the point at which the surviving party is able to hedge or replace the trade.
For cleared trades, IM is normally calculated using an expected shortfall method that aims to protect the CCP [Central Counterparty Clearinghouse] beyond the 99.7 percent quantile. This calculation usually involves deriving a daily time series of historic market data shocks, typically over the 10 years prior.
For bilateral trades, the margin calculation, known as SIMM [Standard Initial Margin Model], is a simpler analytic function that involves the calculation of counterparty risk using predefined parameters. This methodology, due to its simplicity and standardization, enables easier adoption and implementation of the UMR across all counterparties.
From Big to Bigger
The phased approach of the UMR effort has seen the largest market participants already go-live with their IM requirements, and the industry is now moving toward Phases 5 and 6, which will increase the number of counterparties involved and the amount of collateral posted.
From September 2022, it is estimated that an additional 1,000+ entities1 will be subject to UMR for IM.
There have been material increases in the amount of regulatory IM held, purely driven by new trading activity.
For example, 2020 saw a 23%2 increase in the amount of IM collected by the 20 largest market participants globally, despite no new counterparties coming in scope.
The key driver of this increase was new trading activity around the time the Federal Reserve announced its emergency rate cuts in response to the economic threat associated with the COVID-19 viral pandemic.
These types of increases, coupled with the new in-scope counterparties, are set to turn funding initial margin into an even bigger challenge.
The Wider Margin Landscape
The margin landscape is vast, and the regulatory measures impacting uncleared derivatives account for roughly $200 billion2 , according to the aforementioned ISDA survey of 2020, of the total margin out there, which is close to $1 trillion3.
Outside of this, participants must post margin for exchange-traded and cleared over-the-counter (OTC) derivative positions.
Figure 1 – Drivers of Margin
| TYPE | In Billions USD |
| VM | 1,300 |
| SIMM | 218 |
| OTC CLEARED | 353 |
| EXCHANGE TRADED | 486 |
Source: ISDA Margin Survey 2020 & FIA
Figure 2 – OTC Derivatives Margin by CCP
The clearing mandate of 2011 has had a major impact on the margin landscape and caused the numbers to rise to new heights as seen by LCH SwapClear driving the majority of cleared OTC volumes ($220 billion of $416 billion3)
Of the $839 billion of total cleared margin — roughly 50 percent is now driven by cleared OTC derivatives and roughly 50 percent by exchange-traded futures (see figure 1).
The listed margin is driven by CME Group ($152 billion3) and Eurex ($36 billion3)
Regulatory IM is a big industry challenge that continues to grow since the introduction of the UMR regulation. However, when compared to the wider margin landscape, it is part of a much bigger picture.
Flexibility vs. Fragmentation
Participants can enter into, and hedge, risk positions in multiple ways.
For example, a dealer wishing to hedge interest rate PV01 can do so by trading cleared interest rate swaps, interest rate futures or uncleared products, such as swaptions, where appropriate.
This choice allows for more competitive, and hence tighter, pricing, which is a good thing for the market. However, it also results in the fragmentation of liquidity pools, which increases margin costs.
A firm that has zero net risk spread across multiple liquidity pools (bilateral, cleared OTC, and exchange traded), will still have to post margin for the risk taken in each liquidity pool.
If the risk is bilateral, the firm must post margin based on the bilateral risk against each counterparty due to UMR.
If the risk is cleared, then margin must be posted for the risk taken against each CCP independently.
Finding New Efficiencies Through Clearing
The use of central clearing has enabled participants to hold risk more efficiently.
Trades executed with multiple counterparties can be cleared to a CCP where the exposures are netted down. This netting, especially against a highly rated/low risk-weight counterparty, means a CCP is an ideal place for banks to net down risk and reduce costs so they can use their capital more efficiently.
However, the increasing use of central clearing is not enough to tackle the margin funding challenge. Not all products can be cleared, and not all firms are able to clear at the same CCPs.
So, it is therefore unlikely that a firm will be able to entirely net down its bilateral risk to zero. That being said, there is always an optimal solution from a risk and margin perspective for how bilateral risk should be moved to the CCP that adheres to the necessary constraints.
Reducing Risk via Multilateral Optimization
Despite the fragmentation across multiple liquidity pools, the margin rules have created an opportunity — and an incentive — to innovate new ways to systematically reduce risk and margin costs for both cleared and uncleared portfolios.
As participants trade with multiple parties in multiple locations, the key is to approach the issue multilaterally.
Multilateral portfolio optimization creates more opportunities to net down risk in a highly automated and scalable manner, enabling firms (and their counterparties) to benefit from superior risk reduction.
Quantile pioneered multilateral margin optimization by launching a service in 2017 that reduces counterparty risk and the costs associated with funding IM.
Our mission was simple — to help the market tackle the margin challenge as a combined force.
We recognize that participants trade across a vast network; Quantile brings that network together to drive new levels of efficiency.
Trade Together, Optimize Together
Quantile’s IM optimization service works by analyzing the risk configuration of the entire participating network and proposing a set of new market risk neutral trades that deliver margin cost reductions without changing net risk positions.
The resulting optimization proposal is validated and accepted by participants and the execution of new trades is fully automated via electronic trade capture and confirmation platforms, such as MarkitWire and Refinitiv Trade Notification (RTN).
The service allows for risk to be moved across different liquidity pools (cleared and OTC), and gives the freedom for participants to constrain the optimization to suit their requirements.
With an extensive network, including all the G15 banks, the service operates across FX, interest rate, and equity asset classes to deliver participants a material reduction in their IM funding costs – often more than 50 percent.
Just Getting Started
Quantile is determined to make a long-term impact in the derivatives market and to help participants optimize more of their risk, regardless of where they choose to execute or clear.
There is immense capacity to help market participants manage the challenges arising from new regulations through multilateral optimization services.
Quantile will continue to work closely with market participants to develop the material infrastructure required to navigate these challenges and help the industry reach a healthy steady state.
Get in touch
To learn more or to join Quantile’s next run, visit www.quantile.com or contact info@quantile.com.
1 Source: ISDA’s data estimates that between them Phases 5 and 6 will cover some 1100 entities, 315 in Phase 5 and 775 in Phase 6.
2 Source: ISDA Margin Survey 2020 (https://www.isda.org/2021/04/21/isda-margin-survey-year-end-2020/)
3 Source: FIA (https://www.fia.org/initial-margin-combined)
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