Actionable analytics and tools to optimise margin requirements
19 January 2021
The events of 2020 brought the risk of margin volatility into sharp relief. Ingvar Sigurjonsson Managing director, funding and collateral solutions team, State Street Global Markets reviews what happened and what can be done to mitigate future upheaval
Image: stock.adobe.com/Panuwat
Large margin calls, sparked by the COVID-19 pandemic in the first half of last year, have sent many market participants into a scramble for cash and collateral. Some were not able to deliver on their obligations, causing counterparties to close out their positions with longer-term consequences.
Continuous optimisation of margin requirements using pre- and post-trade tools can help buy-side investors start from the best position possible in a bout of volatility. These tools can also help you proactively manage the situation as it is happening. Central clearing counterparty (CCP) margins, in particular, are sensitive to volatility; margin requirements can increase quickly and substantially, as recently seen. To further complicate matters, increased marks to market and stressed risk factors can put pressure on risk limits across counterparties and clearing brokers.
Tools that comprehensively cover your trading portfolio across CCPs and clearing brokers can help you make rapid, well-informed decisions. This can include CCP switches, porting across clearing brokers, or unwinding trades to reduce margin obligations, thus helping you stay under risk limits with the least possible disruption to your portfolio’s return and strategic objectives.
Increased demands on treasury functions
More broadly, recent volatility underscores the need to consider collateral, funding and liquidity holistically. In the traditional model, the front office executes a trade that generates a collateral requirement, the back office pledges required collateral, and the treasury function funds it. Without pre-trade tools, the front office will not know whether its trades are generating the lowest possible funding cost. Without collateral optimisation, the back office will not know if it is selecting the most efficient securities to pledge. And, without insight into the process and access to tools of its own, the treasury function cannot manage funding and liquidity as efficiently as possible.
As clearing has become more prevalent among buy-side market participants, the need for cash to meet variation margin requirements has increased demands on funds’ treasury functions. This is particularly true for pension funds. Those who used to be able to meet bilateral margin requirements by pledging from their expansive bond portfolios now need to produce cash to fulfill obligations the same day and in the right currency. This challenges treasury functions to set capital aside in either cash or high-quality bonds that can readily be turned into cash to meet margin calls. If not done right, this can be costly for the firm. Buffers that are too large create a drag on performance; buffers that are too small can have serious consequences in times of volatility.
It’s in the treasury’s best interest to ensure the front and back office have the tools they need to optimise and proactively manage liquidity. To size and manage buffers appropriately, a treasurer needs to be able to predict potential outflows and understand what levers to pull to reduce outflows when needed. Margin forecasting capabilities and post-trade optimisation analytics that quantify opportunities to lower margin are both essential components of a treasurer’s liquidity management toolbox.
Â鶹´«Ã½ finance and collateral management – two sides of the same coin
Expensive cash buffers can be reduced further if securities held by a fund can be put to work to generate needed liquidity. Access to funding markets is thus another crucial part of liquidity management — whether it’s to generate cash through repos or transform ineligible collateral into eligible non-cash collateral through trade upgrades. Equally important is the ability to deploy excess cash and high-quality securities in reverse repos or collateral downgrades to enhance a fund’s performance. Reliable access to these markets is best achieved by securing multiple avenues to trade. Exploring benefits of diverse sources of liquidity whether through traditional financing/lending markets or evolving peer to peer marketplaces can benefit managers. You want as much of your portfolio to work as possible.
A security holding can be put to work by:
• Pledging the security to satisfy a margin requirement
• Upgrading the security to cash or higher quality, non-cash collateral
• Lending the security out for a fee
Collateral optimisation will routinely suggest the optimal securities from your holdings to meet a margin requirement. The more sophisticated models will also take funding and transformation costs into account, and suggest trade upgrades as appropriate. But securities lending is often left out because it is seen as a separate process from collateral optimisation. This can lead to inefficiencies that negatively affect a fund’s performance. A security that the fund holds may have inherent demand in the market, or is trading ‘special’, which can produce a healthy income or cheap funding for the fund if put on loan. If that security is encumbered as collateral, a manager loses an opportunity to improve the bottom line. A holistic collateral optimisation process should integrate seamlessly with securities finance analytics and incorporate funding costs, transformation costs and lending rates. Collateral optimisation and securities lending both seek to get the most out of a portfolio’s holdings: one aims to minimise costs while the other aims to maximise income. They should be considered as two inter-connected components in the enhancement of a fund’s net income.
A holistic approach to collateral, funding and liquidity
In the best of times, a fragmented approach to managing collateral, funding and liquidity will unnecessarily increase a fund’s costs. In the worst of times, it can lead to acute funding pressures, asset fire sales or missed margin calls. While interacting across departments in a fast-paced environment may seem daunting, timely and accurate data — along with quantitative tools to parse data into actionable analytics — puts decision-makers in a better position to succeed. The difference between success and failure in this space has become all the more apparent in the recent times of market volatility.
Continuous optimisation of margin requirements using pre- and post-trade tools can help buy-side investors start from the best position possible in a bout of volatility. These tools can also help you proactively manage the situation as it is happening. Central clearing counterparty (CCP) margins, in particular, are sensitive to volatility; margin requirements can increase quickly and substantially, as recently seen. To further complicate matters, increased marks to market and stressed risk factors can put pressure on risk limits across counterparties and clearing brokers.
Tools that comprehensively cover your trading portfolio across CCPs and clearing brokers can help you make rapid, well-informed decisions. This can include CCP switches, porting across clearing brokers, or unwinding trades to reduce margin obligations, thus helping you stay under risk limits with the least possible disruption to your portfolio’s return and strategic objectives.
Increased demands on treasury functions
More broadly, recent volatility underscores the need to consider collateral, funding and liquidity holistically. In the traditional model, the front office executes a trade that generates a collateral requirement, the back office pledges required collateral, and the treasury function funds it. Without pre-trade tools, the front office will not know whether its trades are generating the lowest possible funding cost. Without collateral optimisation, the back office will not know if it is selecting the most efficient securities to pledge. And, without insight into the process and access to tools of its own, the treasury function cannot manage funding and liquidity as efficiently as possible.
As clearing has become more prevalent among buy-side market participants, the need for cash to meet variation margin requirements has increased demands on funds’ treasury functions. This is particularly true for pension funds. Those who used to be able to meet bilateral margin requirements by pledging from their expansive bond portfolios now need to produce cash to fulfill obligations the same day and in the right currency. This challenges treasury functions to set capital aside in either cash or high-quality bonds that can readily be turned into cash to meet margin calls. If not done right, this can be costly for the firm. Buffers that are too large create a drag on performance; buffers that are too small can have serious consequences in times of volatility.
It’s in the treasury’s best interest to ensure the front and back office have the tools they need to optimise and proactively manage liquidity. To size and manage buffers appropriately, a treasurer needs to be able to predict potential outflows and understand what levers to pull to reduce outflows when needed. Margin forecasting capabilities and post-trade optimisation analytics that quantify opportunities to lower margin are both essential components of a treasurer’s liquidity management toolbox.
Â鶹´«Ã½ finance and collateral management – two sides of the same coin
Expensive cash buffers can be reduced further if securities held by a fund can be put to work to generate needed liquidity. Access to funding markets is thus another crucial part of liquidity management — whether it’s to generate cash through repos or transform ineligible collateral into eligible non-cash collateral through trade upgrades. Equally important is the ability to deploy excess cash and high-quality securities in reverse repos or collateral downgrades to enhance a fund’s performance. Reliable access to these markets is best achieved by securing multiple avenues to trade. Exploring benefits of diverse sources of liquidity whether through traditional financing/lending markets or evolving peer to peer marketplaces can benefit managers. You want as much of your portfolio to work as possible.
A security holding can be put to work by:
• Pledging the security to satisfy a margin requirement
• Upgrading the security to cash or higher quality, non-cash collateral
• Lending the security out for a fee
Collateral optimisation will routinely suggest the optimal securities from your holdings to meet a margin requirement. The more sophisticated models will also take funding and transformation costs into account, and suggest trade upgrades as appropriate. But securities lending is often left out because it is seen as a separate process from collateral optimisation. This can lead to inefficiencies that negatively affect a fund’s performance. A security that the fund holds may have inherent demand in the market, or is trading ‘special’, which can produce a healthy income or cheap funding for the fund if put on loan. If that security is encumbered as collateral, a manager loses an opportunity to improve the bottom line. A holistic collateral optimisation process should integrate seamlessly with securities finance analytics and incorporate funding costs, transformation costs and lending rates. Collateral optimisation and securities lending both seek to get the most out of a portfolio’s holdings: one aims to minimise costs while the other aims to maximise income. They should be considered as two inter-connected components in the enhancement of a fund’s net income.
A holistic approach to collateral, funding and liquidity
In the best of times, a fragmented approach to managing collateral, funding and liquidity will unnecessarily increase a fund’s costs. In the worst of times, it can lead to acute funding pressures, asset fire sales or missed margin calls. While interacting across departments in a fast-paced environment may seem daunting, timely and accurate data — along with quantitative tools to parse data into actionable analytics — puts decision-makers in a better position to succeed. The difference between success and failure in this space has become all the more apparent in the recent times of market volatility.
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