Collateral optimization, should I implement, or shouldn’t I? This is a question which every house who trades any class of derivatives should be asking themselves. Hopefully the following passages give more food for thought to this dilemma.
Optimization has been a hot topic for a long time, first coming to the attention of many buy-side firms when preparing for the implementation of Dodd Frank in 2012. The concern back then was how can portfolios be effectively managed to meet the extra margin demands of the central counterparties for clearing? At that stage solutions available to buy-side firms were limited, it was common practice to simply accept the figures of the clearer or counterparty without validation, far from ideal, far from efficient, and certainly risk mitigation was skewed to be in favour of the sell side.
Numerous regulations were introduced in the last 10 years, which has meant resources and budgets have been purely focused on ensuring compliance with the respective initiative e.g. clearing, reporting, reconciliation etc. Any additional development needs were therefore pushed down the priority list.
The front office takes a greater role in collateral management
Historically collateral management was managed through close collaboration between the front, middle and back office teams, but as more demands have been made on firms, due to increased margin requirements, it has required the front office to take a much greater role in determining how assets are utilized post trade, as well as estimating how much of the eligible assets available should be retained to meet future demands. This has been a significant change resulting in changes to trading strategies, especially when managing margin requirements during volatile periods of time.
Manual practices were introduced to manage the approach whether the creation of new collateral/business reports, review of cash/asset priorities or the use of mathematical formulae. This worked to a degree, but it wasn’t scientific in its approach, thus had significant deviations, plus resources were required to create and review the data available before reaching a subjective decision. Optimization changes this to a much more streamlined framework which adopts scientific methodologies.
The role of Uncleared Margin Rules
Interestingly it is the Uncleared Margin Rules (UMR) regulation which has resulted in this topic coming to the fore once again. UMR began a phased approach in 2016 finishing in September 2022, but it was the last two phases which started to see more buy-side firms impacted, and this meant more assets had to be utilized to meet the initial margin demands imposed by UMR. Additionally, as cash is ineligible for initial margin movements it naturally led firms to not only review how best to manage their portfolios for this new regulation, but to also investigate how they meet their demands in relation to managing both variation margin and mark to market exposures. As a result, firms needed to determine how best to utilize their portfolios, and optimization started to be seen as the solution to the problem.
The role of optimization on alpha
Historically optimization was always considered to be most relevant in the non-cleared OTC space, but positively, due to advanced technologies, capabilities have now evolved to cover all derivative classes, providing much more flexibility for clients to adopt into their business practices. Indeed, the benefits of implementing such a solution to other derivative classes can be considerable and should not be underestimated as it negates the reliance to simply accept the calculation of initial margin by their clearing or prime broker. In my experience it is astonishing the differences that can be seen, thus implementing a scientific model of this nature ensures initial margin is validated, controlled, and significantly maximizes the amount of investible cash available which leads to the potential of increasing alpha to the fund.
Do you have collateral resilience?
True collateral optimization involves an adjustment to the target operating model which ultimately leads to collateral resilience, but what is collateral resilience? 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 close out. Given the siloed nature of technology and data in many firms, the exact implementation of a collateral resilience program will vary, but it should include the following core pillars:
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. This reduces the ultimate need for collateral and is thus a key foundation of the entire resilience model.
A robust collateral optimization model will reflect the true value of collateral inventory to the firm, including trading demands and funding costs. A mathematical optimization can then be applied that ensures the largest possible amount of high-quality liquid asset is retained in the unencumbered pool to allow flexibility when shocks arrive.
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 levels, margin levels and collateral values, as well as legal terms with counterparts such as eligibility schedules.
Of course, none of this is easy to implement and there are common challenges that many firms encounter, including:
- Understanding inventory availability and collateral mobility across the firm. Too often, firms default to posting cash or 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 and prime brokerage portfolios are often segregated at both business and technology levels, and harmonizing 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 optimization 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.
While the above describes a few of the solutions available, each one realizes specific benefits, and thus maybe the question isn’t whether optimization is a necessity or a nice to have, but should be which parts of the optimization solution are a necessity to you and which are nice to haves?
The benefits of using optimization tools
Each firm will need to consider if their volume of derivative trading warrants an optimization solution. It can categorically be stated that firms with active derivative platforms will recognize a clear differential if one house has optimization and the other does not. The reason is that those who don’t, run the risk of introducing high collateral costs to the portfolio, thus reducing investible cash or the ability to utilize assets within a financing program to generate income. Additionally, in the event of a stress situation insufficient assets available may lead to the need to borrow collateral at a very high cost. Alternatively, firms who are optimized will reduce the cost of collateral used, thus increasing the potential for generating alpha, and in times of stress will be able to react and adjust more efficiently. Examples of the benefits clients have realized who use optimization tools include:
- 58% reduction in portfolio drag, because of optimizing the cost of funding the margin requirements
- Increased High Quality Liquid Assets (HQLA) being freed up to increase annual lending program revenue
- Reduction in the initial margin requirement through reconciliations leading to a 5 million USD P/L impact pa
Collateral risk is real risk
In summary initial margin has become a hot topic because of new regulations and recent extreme global events. The increasing demand for collateral means investment managers of all styles are required to focus on more than just their daily regulatory and operational compliance. Collateral risk is a real risk and should be controlled and monitored with equal focus to that of market and credit risk. This is particularly relevant in volatile markets and notable with regard to known recent examples where an energy firm saw margins increase by 600%, and a wealth manager who had to unwind $400 million of positions. This requires a strategic approach with integration across business lines and technology silos, and novel tools that allow for sophisticated control and transparency.
Is optimization for you? Ask yourself these questions:
- How do you calculate and validate initial margin across each derivative class?
- How do you determine how much of eligible assets should be retained for future margin requirements?
- How do you prioritize which assets to use?
- Who are the decision makers and how do you resource?
The answer to the above questions may lead to changes front to back, it may equally lead to the business decision to introduce an optimization tool. But at the very least it will define a front to back optimal workflow for collateral management, and that is a good thing!
If you would like to talk more about collateral optimization, please contact me directly at [email protected].
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