Margin Optimization and the Cost of the Trade

THE KNOWLEDGE XXXXXXXXXXX TECH SPOTLIGHT

Margin Optimization and the Cost of the Trade

Banks have largely absorbed the Leverage Ratio and the Liquidity Coverage Ratio and are taking on the next challenge: maximizing their balance sheet efficiency in a return to profitability. One area getting new attention is margin optimization, where banks, insurance companies, hedge funds and others replicate the margin model that they and their trading partners and CCPs use across product lines. The end result of this optimization is smarter decision-making about what trades to make based on cost savings in margin utilization. For larger participants in collateralized trading activity, this could translate into tens of millions in annual savings across Initial and Variation Margin.

BY JOSH GALPER, MANAGING PRINCIPAL, FINADIUM

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focus on cost management The Components of Margin mization (see Exhibit 2). With technology, makes sense given the real- Optimization however, it becomes possible to calculate ities of the regulatory envi- The question that margin optimization the funding impact of margin, also called ronment. In a 2014 study, seeks to answer is not whether costs can Margin Valuation Adjustment (MVA). The Clearing House looked at be reduced – in most cases they can – but Incorporating multiple products into Athe cost of regulatory compliance charges how banks and investors can best achieve one margin optimization calculation is a for capital-related rules at six major US this end result. Currently, margin is either critical part of the process as well, and one banks. The study found that new regula- determined on a trade by trade basis or is that supersedes traditional siloes in favor tions were set to increase compliance costs allocated within a business unit and often of an enterprise-wide view of margin by between US$27 to US$45 billion annu- after the fact. Margin optimization can costs. The more business units are incor- ally (see Exhibit 1).1 This is an average of move decision-making to pre-trade and porated in margin optimization and can US$4.5 to US$7.5 billion per bank, with the help determine if a specific trade is help- be included in a dynamic feedback loop, Net Stable Funding Ratio (NSFR), the Sup- ful or harmful to margin requirements. the more that the entire organization can plementary Leverage Ratio, the GSIB cap- Decisions about margin on an institution- benefit from the output. It is important ital surcharge and the Liquidity Cover- wide basis cannot be gathered in the time also to note that margin optimization is age Ratio (LCR) as the four largest items. span of a phone call without technology; not the same as collateral optimization; While there is not much to do about the performing this analysis in real-time, and margin optimization deals specifically GSIB surcharge, margin optimization can capturing diverse data points, such as cost with the requirements of counterparties help control exposures that contribute to of capital and available inventory, is the and netting, whereas collateral optimiza- the Leverage Ratio, NSFR and LCR. fundamental idea behind margin opti- tion takes a bigger view of firm-wide collateralized trading requirements.

Exhibit 1: Estimated range of compliance costs by regulation (six large US banks) (US$ billions)

14 Lower bound Upper bound 12

0 GSIB capital Long-term debt Supplementary Liquidity Net Stable Deposit fund surcharge Leverage Ratio Coverage Ratio Funding Ratio assessments

Source: The Clearing House

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Exhibit 2: Inputs to margin optimization

SA- Initial CCR Margin

Cost of Hurdle rate Static capital charge

Inventory LCR

Netting

Margin optimization

Source: Finadium

Modeling Margin Requirements Office of Financial Research showed that products (2 vs 5 days). at Banks and CCPs when netting, margin and guarantee fund CCPs have themselves expanded their Margin rules play an important role in contributions are taken into account, the offerings to include margin optimization determining how and whether to trade. total cost of clearing swaps on a CCP may both for individual trades and for port- There are countless examples of margin in fact be more expensive than a bilateral folios. LCH’s Spider algorithm seeks out being the deciding factor on counter- transaction.2 listed positions that could net against OTC parties, for example on September 1, 2016 Each of these models work somewhat positions and calculates both for portfo- when some countries adopted non-cleared differently. According to the CME, “SPAN lio margining. Eurex Prisma’s Liquidation derivatives margin rules while others evaluates overall portfolio risk by calcu- Groups cover futures, options and swaps. did not, which led to a halt in trading as lating the worst possible loss that a port- Users can select CCP margin optimization new rules were reviewed. Entire product folio of derivative and physical instru- tools in conjunction with internal models sets are also winners or losers when it ments might reasonably incur over to reduce risk by moving positions from comes to margin, notably cleared futures a specified time period (typically one one clearing account to another, on or versus cleared swaps products. Futures trading day).”3 Historical Value-at-Risk across multiple CCPs. The next impetus exchanges get to set their own margin (HVaR) meanwhile looks at a historical for more transparency across CCP margins rules, for example a 1-day time horizon pattern and seeks to create an X% con- might come from MiFID II, where more and the use of the SPAN model for Deliv- fidence interval for determining a pos- trade execution details will be required, erable Swap Futures compared to a 5-day sible default. SPAN and VaR are not the and where concentrating margin at one time horizon and a 99% confidence HVaR only models at CCPs either; several CCPs, CCP may reduce client costs. model (see Exhibit 3). ISDA’s SIMM model including Eurex (Prisma), LSE (PAIRS) and uses a Sensitivity Based Approach, a 10-day ICE (MAPS), have moved to their own VaR- The Revenue Impact and What-If time horizon and a 99% confidence inter- based approaches for listed products. The Scenarios val. ISDA’s SIMM Initial Margin is expected difference between OTC and exchange- The revenue impact of margin optimi- to be 1.4X greater than margin for a cleared traded derivatives (ETD) is going to be the zation depends entirely on the firm, their trade, although a recent study by the US holding period, which is shorter for ETD portfolio, and whether trades are cleared

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Exhibit 3: Margin calculation inputs on ERIS, ICE and CME

Eris ICE CME ISDA SIMM

Swap Cleared OTC Standards Flexes DSF Bilateral Futures Swaps

Days 2 5 1 1 5 10

Sensitivity Model SPAN HVaR SPAN SPAN HVaR Based Approach

Confidence N/A 99% N/A N/A 99% 99% Level

Sources: ERIS, ICE, CME, iOSCO, ISDA

Exhibit 4: Eris swap futures savings vs. OTC by contract maturity (Percent)

0 2 3 4 5 7 10 12 15 20 30

Source: Eris Exchange

Issue 05 Securities Finance Monitor 39 THE KNOWLEDGE XXXXXXXXXXX TECH SPOTLIGHT

Exhibit 5: What clients of collateral technology vendors are trying to achieve (Percent of responses)

2015 2016 60

0 Balance sheet management Business profitability

Source: Finadium

or non-cleared. While a global figure on through best options based on the margin rules have imposed on financial mar- potential savings is unknown, individual requirements of counterparties, firms can kets in the last six years. A move towards observations show that futures margin systematically reduce their costs by select- margin optimization however is increas- costs beat cleared swaps: an analysis ing the best inventory and not overpledg- ingly seen as a change that’s good for busi- from Eris Exchange showed that margin ing. A robust what-if algorithm includes ness and also important for competitive on their swap futures ranges from 41% to the following steps in an iterative process: positioning. If one institution does not 58% better than cleared swaps, depend- • Identifying the cost of the initial build out their capacity for margin opti- ing on the maturity of the contract (see transaction. mization, it will cede pricing advantages Exhibit 4). Further, using a margin opti- • Demonstrating which variable fac- to others that have taken this step forward. mizer beats posting whatever margin hap- tors are negatively impacting the Margin optimization also fits into pens to be available. Under current US trading cost. a broader technology trend: banks are rules, but not proposed European rules, • Providing alternative trading sce- moving past regulatory concerns and client margin will be captured as part of narios that are driven by lowering looking at a return to profitability. In a the Leverage Ratio. For a bank that is cal- capital costs. November 2016 Finadium survey of collat- culating its margin liabilities with no for- • Potentially recommending a eral technology management companies, ward thought to netting requirements change to certain securities at the 50% said that their clients were trying to across CCPs and bilateral counterparties, center of the trade for reasonable achieve profitability through their tech- margin costs could make an unpleasant alternatives. nology investments (see Exhibit 5).4 This impact on Leverage Ratio liabilities. The • Running a portfolio simulation on is up from 23% in 2015. Balance sheet man- better plan by far is to assess portfolio- existing plus new positions. agement was also important in 2015 but wide margin optimization opportunities. saw a smaller increase in prioritization What-if scenarios are an important Investing in Change in 2016. part of understanding the revenue impact Not many people love change, espe- We expect that margin optimization – of margin decision-making. By sorting cially the level of change that regulatory like collateral optimization before it – will

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become a regular part of financial tech- References: 3. http://www.cmegroup.com/clearing/ nology within the next two to three years. 1. “Working Paper No. 4: Quantifying the risk-management/span-overview.html This is a logical step for banks and inves- Impact of Macroprudential Regulation on 4. “Collateral Management Technology Vendors tors, and sets the stage for a much greater the Largest U.S. Banks,”The Clearing House, in 2016: A Finadium Survey,” Finadium, understanding of a firm’s margin, collat- November 2014, available at https://www. November 2016, press release available at eral and even capital requirements on theclearinghouse.org/~/media/files/ http://finadium.com/finadium-report-desc/ an enterprise-wide level. Taking advan- association%20related%20 collateral-management-technology-vendors- tage of trade compression opportunities documents/20141119%20wp%20no%204%20 in-2016-a-finadium-survey/ achieves a similar objective. Margin opti- quantifying%20regulation%20impact. mization is an important move forward pdf?la=en for banks looking to increase profitabil- 2. Does OTC Derivatives Reform Incentive ity in collateralized trading businesses; Central Clearing,” Samim Ghamami and Paul the banks who manage to implement Glasserman, Office of Financial Research integrated bilateral and cleared margin Working Paper, July 26, 2014, available at solutions, across ETD and OTC transac- https://www.financialresearch.gov/ tions, will be the winners of this market working-papers/files/OFRwp-2016-07_Does- transformation. OTC-Derivatives%20-Reform-Incentivize- Central-Clearing.pdf

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