Our Q&A with Chris Walsh, the CEO of Acadia, focuses on the world of derivatives after the UMR reforms take hold.
Chris Walsh
(FTF News recently spoke with Chris Walsh, the CEO of Acadia, about the world of derivatives trading after the Uncleared Margin Rules (UMR) reforms take hold — the UMR Phase 6 deadline is September 1, 2022. An industry veteran, Walsh held key roles at NYSE Technologies, NYFIX, and Thomson Financial before Acadia, which was once known as AcadiaSoft. Beginning with a mission to automate manual margin call processing, Acadia has expanded to become a provider of an integrated, data-driven risk management infrastructure that includes exposure and settlement reporting. Acadia’s Initial Margin (IM) Risk Generator (IMRG) won the 2022 FTF Award for Best Compliance Solution.)
Q: How do the UMR regulatory overhaul and similar efforts help break down collateral margining and risk management silos?
A: The Uncleared Margin Rules (UMR) reforms make risk mitigation more of an operational function across the firm. Most noteworthy, both the dealer and its counterparty now need to calculate risk. Not only that, those two separate calculations have to be reconciled every day.
This is substantial and requires a new capability in the operational area. Not only do you have to leverage the risk expertise that has historically sat within a risk function outside of the day-to-day operation, but you also have to bring that into the collateral operation function.
Additionally, disputes also have to be resolved.
An operational person who’s predominantly been responsible for managing differences by looking at reconciliations now needs to work hand-in-hand with risk experts to understand different views of risks seen between them and their counterparts.
The other big impact that is causing this breakdown of silos is that the financial impact of margin — sometimes referred to as MVA [margin valuation adjustment] — is now more controllable by collateral parties and therefore can be optimized.
UMR has also added transparency.
Before UMR, a bank would never consider sharing risk sensitivities that are a core piece of pricing with their counterparties. So, I think when most people approach risk here, it’s really been from a perspective of how much information do I need to share that I didn’t share prior to UMR? And how do I best do that?
So, we embedded access controls into our service at a much more granular level than ever before. What we have to do is reconcile risk between parties, which means we’ve received a number of very detailed views of risk between trade counterparties, and we reconcile them. We can flag disputes that need to get resolved.
But the information shared that each party sees from one another is just a summarized view.
We still protect the confidentiality of the more detailed data.
Only in instances where they have disputes, differences — significant differences between one another — are they allowed to, and would they have permission to, access that more detailed level between one another.
Q: So, once the silos gave way, when did it make sense to build new connections among the collateral, margining and risk management processes?
A: Well, to an extent, immediately.
Once a firm is in scope for UMR, they have to start operating differently. They have to start monitoring — even if they’re in scope but still haven’t reached the threshold. In some cases, this means they have to trade differently.
They have to take a look and factor in trading counterparts — how they should best distribute their trades to maximize their capacity and in some cases, to stay under the threshold to limit their collateral.
How they do that right away is ultimately not through the perfectly integrated system — they take it piece by piece. Typically, what you’re going to see is risk integrated with collateral operations first to focus in on how to deal with disputes.
Then you see the next steps where you can see integration to the collateral management function, so that collateral optimization can be considered.
And then beyond that, you see integration with agreement and agreement controls.
It is a multi-step process for firms to achieve this, which will extend many years after UMR is in place.
The early phase clients that we’ve brought on for UMR, largely started off using our IMEM [IM Exposure Manager] service. And what that service does is connect them to all their counterparties to calculate SIMM from risk calculations and reconcile the views between parties.
As more of their counterparties came into scope, these firms have expanded their capabilities and integrated more closely with the collateral and margining process.
In later phases, clients who had never had to calculate risk started coming into scope for UMR.
A majority of these clients are entrusting Acadia to perform those risk calculations on their behalf with our vertically integrated IM solution. All processes that historically have been more manual with variation margin (VM) and disconnected are now going to be fully integrated.
Q: So, among the firms that are in scope for UMR, has there been a resistance to the idea of linking the collateral margining and risk management steps? Or are most firms really on board with it?
A: There hasn’t been resistance, but it does spur a number of questions for firms.
They’re asking themselves: “How am I going to best do it? Do I have the resources internally to do this or do I have to look to my fund administrators? Should I look to solution providers like Acadia in order to do it?”
Firms that are well positioned to do a lot of these things themselves are on board with it. These are firms that have risk functions and the ability to digitize agreements in place already and are able to integrate collateral and risk and connect with Acadia as part of the process.
But there is a large segment that has totally new requirements and those firms are turning to fund administrators and entrusting “their custodian,” or the company that is managing their collateral to provide an end-to-end solution.
From our standpoint, we’ve already partnered with the majority of fund administrators in the market and that’s one of the reasons why we were able to quickly onboard this full scope of clients coming in.
We didn’t have to do it ourselves — we already had those partnerships in place.
Q: What have been the benefits expected and unexpected from putting the connectivity pipes in place for collateral margining and risk operations?
A: One of the primary benefits is that it adds significant capacity to our financial markets by unlocking capital that would otherwise be unnecessarily locked up with the rules.
So, by setting minimum collateral amounts and minimum capital amounts for firms, what the regulations are saying is that you have to set aside “X” amount of your capital, in order for you to even trade with clients. And it’s a significant amount if you’re not optimized, so how do you do it?
If you don’t focus on redistributing in a smart way, you wind up having a large amount set aside that’s all capital but can’t be applied to any of the functions that our capital markets serve.
So, the biggest benefit in the broader view here is that we’re putting in place a series of constraints to eliminate the type of risks we saw back in the financial crisis. And if you do it in a highly electronic, joined-up way, it actually does not create an attack on capital that would otherwise be there.
It also allows you to have a system that optimizes around these constraints so that it doesn’t add that capital and keeps that free capital available for things that we all count on.
I’d say at the next level it also enables a more accurate OTC [over-the-counter] marketplace. And I think that’s critical for the long-term sustainability of the OTC markets.
A lot of people’s knee-jerk reactions to seeing problems in the broader financial markets [during the Great Recession], which were really caused by mortgages, was that OTC instruments should be cleared over time. By doing that, you’re restricting the markets — clearing restricts the flexibility that any market participant or dealer could provide to their end client.
By making the OTC a more accurate market, you wind up having two sides calculating risk and reconciling with one another every day.
We’re eliminating the vulnerabilities that exist in the market when you only have one side calculating and the other side just accepting. You have more risk-aware people on both sides.
Q: As of today, we’re in a bear market. Will that have any dampening effect on these firms?
A: These changes are being put in place largely because volatility exists in the market. And in a bear market what we saw is days of substantial volatility and I think we’re going to continue to see that over the course of the foreseeable months.
Having regulatory-agreed margin in place that really serves as the minimum between parties can make everyone more assured that these markets can absorb these types of changes. And I think what’s important for people to understand — because sometimes people say regulatory margin doesn’t work in all cases — is that, for the most part, it does.
Q: So, what will the derivatives operations world look like when all the UMR phases are in place and then working?
A: On day one, you’ll see improvement over what we’ve seen previously. And we’ve already seen operational functions being augmented with risk expertise.
Then what we’ll see is some of our risk functions will become more operationally aware, and they will be augmented with people who have been operational experts in the company.
What we’ll see going forward — if you take a longer view of where that evolves to — is that operations, as they are seen today, will at some point cease to exist.
Today’s operations will be replaced with a highly analytic team focused on addressing the more substantial risks and substantial exceptions that come out of the process.
So, this process will become very “exceptions-only” because the automation that has come into the market, as part of these phases, will be pinpointing the high risks exceptions and resolve them because the right people will be part of the process.
It won’t be operations people that then have to pass it on to other functions.
Q: Would some of the reconciliation vendors be jumping on board with this? Would this be an opportunity for them?
A: I think there’s an opportunity, but I think what you’ll see is more integration between vendors.
What we do see is the market coming together as more of an integrated post-trade ecosystem that will evolve and positively impact the direct players.
This will also impact a lot of the quantitative analytic firms that are providing some value-added optimization services, and some of the settlement providers that are supporting communication down to settlement channels.
Q: Firms will not be able to rest on their UMR laurels. Among the issues they will have to think about, are the operational challenges of digital assets such as tokens. How can firms apply their new collateral margining, and risk management connections to the emergence of digital assets?
A: When we look at our process, we see real-time settlement as a natural next step toward integrated risk management.
What will emerge is going to be a very dynamic, event-driven risk, margin, and collateral environment, that’s constrained by a very slow settlement process — in some cases, multi-day settlement.
In real-time, you can be arranging and agreeing how to move risk between you and your counterparts. But in a lot of cases, if you’re using security as collateral, you’re going to wait days before that happens.
So, the speed of settlement has to pick up, and the drivers for it go beyond just the typical operational drivers. More and more capital assets are being required as security because IM requires security-based collateral. And when firms look at a lot of their securities, they feel like they don’t want to post them as collateral because they have multi-day settlement cycles — they can’t get them back.
One concept that will ultimately have an impact on this is using a digital token cloud —by this I mean, digital tokenized collateral to replace the idea of exchanging securities between parties. By doing that, it allows firms to have access to maybe an illiquid asset, and post that as collateral. But your trading desk needs access to that illiquid asset, on-demand when they need it.
Historically, you’d have to only put up more liquid assets. Now, you can start thinking about using a different mix of your assets and posting them as collateral and covering them as collateral.
Today, you get collateral back after the number of days of settlement that go on. But if you knew that you put this asset there and you can take it back when your trading function needs it, that’s going to be a big benefit to everyone in the markets and a big benefit to the market too. That’s one of the areas where I see digital ledger technology [DLT] helping us.
Q: And, where would you say DLT is right now, as far as its development?
A: We have a couple of proof of concepts, partnering with some digital ledger providers in the market today.
There are a number of steps from the initial incubation before it becomes mainstream. But we do see these channels starting to open up and, as they do, firms will understand the benefit, particularly as front offices start understanding how they can reduce their funding costs and give them more options in terms of meeting their collateral obligations.
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