Estimated 6 minute read
- Liquidity risk charges are included within initial margin requirements and imposed by an increasing number of CCPs – including Eurex and LME Clear. Understanding how to allocate positions optimally between clearing brokers is key to minimising margin requirements.
- The Liquidity Add-on can be greater than the base initial margin for large positions as it is a non-linear calculation, dependent on the size of position.
- Some derivatives users have seen their margin increase by 40% due to this additional charge, and in some extreme cases by up to 70%.
Reasons for Change
In the future, more and more CCPs will charge a Liquidity add-on. The original exchange traded margin algorithms were relatively simple scenario based calculations. However, increasing complexity in the exchange traded contracts available (for example multiple options on the same underlying including weekly, serial and mid-curve) and the way they are traded means they are no longer fit for purpose. In particular, the older algorithms, such as SPAN, do not effectively support calendar spreads or cross contract offsets.
Any CCP that is changing its margin algorithm, or any exchange that is changing the CCP that it uses, will need to obtain regulatory approval. To do this they will need to include additional risks within their margin calculation, including Liquidity Risk.
To date, the CCP that has created the biggest impact in the market has been Eurex and their move to Prisma, a VaR based methodology that covers all their products, including OTC and exchange traded derivatives, as well as cross margining. They have successfully migrated all their customers from their previous Risk Based Margin to the new PRISMA methodology.
A number of other major CCPs are in the process of making this change in margin methodology. This will result in the introduction of a Liquidity add-on.
The Introduction of Liquidity Risk
When a CCP changes its margin algorithm or an exchange changes its CCP, it needs regulatory approval. This approval will only be given if the risk management is shown to conform to all current regulation, which in the case of CCPs is Principles for financial market infrastructures (PFMI), published by the Committee on Payments and Market
Infrastructures (CPMI) and the International Organization of Securities Commissions (IOSCO).
In particular, further guidance on the PFMI provided by the Bank for International Settlements (BIS) and IOSCO included a specific section on position liquidation. (see footnote for full text).
Any new CCP margin model must incorporate market liquidation costs, including bid/ask spreads.
This means that when a CCP moves to VaR or wants to add new products that require a margin methodology change, they will need to include a Liquidity add-on within their calculation to gain regulatory approval.
Calculation of the Liquidity Add-on
CCPs that include a specific liquidity margin have generally set liquidity factors based on the size of the position relative to normal market activity. A table of factors for different position sizes is provided and used to scale up the margin, generally calibrated to increase the VaR component to an implied longer close out period.
An additional charge may also be applied to cover the bid/ask spread in closing out the position. The size of this charge can be adjusted based on the likely impact of any close out on spreads in the market.
Consequence of the Liquidity Add-on
Without Liquidity Add-on, margin will be linearly proportional to the size of the position. So the margin for a 100 lot position will be 10 times the margin for a 10 lot position. With Liquidity Add-on this is not the case. The margin is no longer linear and will be punitive for large positions.
The following graphs show the way that the Liquidity Add-on scales for Eurex Bund Futures:
One exchange has implemented a relatively simple charge based on the size of the position. The charges are such that for positions that are considered to be large compared with the overall open interest, the liquidity charge will actually be greater than the base initial margin.
So, understanding how Liquidity Add-ons are calculated is key to minimising margin.
Why This is a Problem for Certain Strategies?
Think of a typical Relative Value strategy – buying 2 year and selling 10 year bond futures. The normal assumption would be that to optimise the risk, all positions should be cleared with a single clearing broker. However, if the position is large, the Liquidity add-on will make this a sub-optimal solution. In calculating the charge, no benefit is given for having off-setting positions. The outright position in each product is considered separately.
Assume you have a position of bought 100,000 Schatz and sold 20,000 Bund Futures.
If this business is allocated to a single clearing broker then the total margin will be EUR 34,950,953 including a Liquidity Add-on of EUR 4,694,951.
If this same position is allocated across 2 clearing brokers, then the total margin will be EUR 32,7078,266 including a reduced total Liquidity Add-on of EUR 2,451,264.
Hence a margin saving of EUR 2,243,678.
Allocating Business Taking Into Account Liquidity Add-on
With the introduction of the non-linear Liquidity add-on, the traditional way of allocating business between clearing brokers, putting all positions from one market at the same broker, is now sub-optimal. Any large outright position will incur significant margin in order for the CCP to cover the risk of close out on default. If you allocate your trades by market it may give the maximum position offset, but also maximum Liquidity add-on.
Assume you have the following Eurex positions – a combination of fixed income and equity, with the fixed income positions allocated to Broker 1 and the equity positions allocated to Broker 2:
|March 2018 Bund 164 Call Option||Long 1,000||Broker 1|
|March 2018 Bund 163 Put Option||Long 1,000||Broker 1|
|June 2018 DAX 16500 Call Option||Long 1,200||Broker 2|
|June 2018 DAX 16000 Put Option||Long 1,200||Broker 2|
The initial margin calculated will be as follows:
|VaR Margin Component||Liquidity Add-on||Total IM|
A more efficient way of allocating positions needs to be found which will minimise the margin calculated by clearing brokers. This means optimising between maximising the offsets between contracts and minimising positions for a given product allocated to a broker.
A simple split of the positions between the 2 clearing brokers could be as follows:
|March 2018 Bund 164 Call Option||Long 500||Broker 1 & 2|
|March 2018 Bund 163 Put Option||Long 500||Broker 1 & 2|
|June 2018 DAX 16500 Call Option||Long 600||Broker 1 & 2|
|June 2018 DAX 16000 Put Option||Long 600||Broker 1 & 2|
This will result in the following initial margin:
|VaR Margin Component||Liquidity Add-on||Total IM|
This is a margin saving of EUR 1,359,864 or 15%. And if there were four clearing brokers available the total margin would be reduced to EUR 7,159,572 which is a 22% margin saving.
How OpenGamma can help
- Initial Margin reduced by up to 40%
- Reduction achieved by reallocation of as few as 5 contracts types between FCMs
- Freeing capital to increase leverage, drive higher returns and reduce counterparty exposure
- Previously firms have relied on passive monitoring of initial margin across accounts to try to identify large changes
- Recent increases in margin consumption have begun to put pressure on unencumbered cash levels
- No visibility into the drivers of margin beyond the margin reported by their clearing brokers at account level
- No visibility into how effectively they were allocating business between their brokers to minimise initial margin
- Low awareness of the liquidity add-ons charged by the CCPs
- Independent validation of margin charged by clearing brokers to ensure correct amount of collateral is posted
- Daily tracking of initial margin down to each trader and strategy to identify primary areas of margin consumption
- Daily tracking of margin efficiency to assess opportunities to reduce margin
- Daily recommendations to port trades and positions between brokers to reduce margin through better offsets or reduction of add-ons
- Year in Review 2020: A Difficult Year for Margin
- OpenGamma Selected by Castleton Commodities International
- Stress Testing European Pension Funds – Denmark in Focus