Bracing for a $2 Trillion Margin Call
By Will Rhode, TABB Group, and Sol Steinberg, OTC Partners
Originally published on TABB Forum
The buy side will need to deposit approximately $2 trillion in cash and other eligible assets at central counterparty clearinghouses in order to meet the new clearing requirements for swaps. In this collateral-hungry world, the ability to anticipate, source, deliver and reconcile funding requirements in real time will prove essential.
Before the financial crisis and reform, buy-side firms were content to use Excel spreadsheets, email confirmations, and manual processing to calculate their aggregate risk exposure and to manage their books and records for their OTC portfolios. Counterparties would negotiate a valuation and make payments based on mutually agreed upon amounts. Trades would be confirmed with a simple: "You're done."
This is no longer an option. TABB estimates that the buy side will need to deposit approximately $2 trillion in cash and other eligible assets at central counterparty clearinghouses (CCPs) in order to meet the new clearing requirement for swaps. Capital is a scarce resource that cannot be squandered by overestimating a margin call. Efficient collateral usage will become an integral and growing factor in a firm’s financial and risk management strategy.
In a collateral-hungry world, the ability to anticipate, source, deliver and reconcile funding requirements in real time will prove essential. The more precise the buy side is in understanding risk, the better it will be at optimizing funding, with the potential to repurpose freed up capital to fund more lucrative trading opportunities. Historically, dealing with margin management was a reactive function conducted at the end of the trading cycle, performed within administrative and back-office operations, often manually.
Today, industry leaders on the buy side are upgrading their technology todeliver a holistic view of their global collateral assets so they can explore multiple sourcing and funding options in real time.Risk analytics, collateral optimization and faster trading processes will give these firms a competitive advantage. Some are finding that a front-to-back solution is in order, one that covers the entire OTC trade life cycle, across all groups. Meanwhile, others are stitching together disparate systems from multiple vendor and FCM-provided tools. Those furthest behind the curve are in pure catch-up mode, utilizing every available resource just to stay compliant.
The most impactful trends among bellwether firms include:
- Straight-through-Processing (encompassing both trade execution and central clearing);
- Independent margin calculation and swaps portfolio pricing tools;
- Reconciliation tools that can account for margin call discrepancies, either at the CCP or clearing intermediary level, or both;
- Transaction Cost Analysis (TCA) tools that can incorporate data from the trading process as well as feeding data from the back office into the trading process.
The aim of these initiatives is to optimize the entire workflow whereby all areas have a complete view of what’s going on with the trade. The pre-trade function is directly fed from the asset and ancillary services, while trade execution depends on pre-trade functionality, just as the back office relies on STP from the middle office. Every department is dependent on the next, and the optimal workflow creates a closed loop on risk and valuation data, as well as tactical information pertaining to TCA. Only with this level of workflow transparency and seamless connectivity can funding be optimized, latency minimized, trade costs reduced and Best Execution mandates properly satisfied.
That being said, there is a portion, perhaps even an unhealthy majority, of the buy side that is overwhelmed by the clearing mandate and that remains stubbornly passive in the face of the challenges ahead. Treating margin purely as a post-trade consideration, accepting CCP margin and swaps valuations as law with no efforts to validate those calculations, pre-funding their swaps portfolios to avoid intraday margin calls, and having no intention of implementing risk analytics or collateral optimization systems – these are just some of the mistakes that will lead to portfolio performance drag and, in the extreme, result in trade failures, breaks, losses, default scenarios, legal claims, and perhaps firm-wide failures.
While 2013 will be remembered for compliance, clearinghouse and Futures Commission Merchant (FCM) selection, as well as the basics of plumbing and testing, 2014 will be the year the buy side starts to take control of the capital commitment process. The introduction of new capital-oriented workflow tools will lay the groundwork for the ultimate goal of running a swaps portfolio that demonstrates both cross-product margining efficiency and versatility (in terms of product selection) that will have to be managed through an enhanced risk management process.