There are so many signs that summer is over; the weather suddenly feels autumnal, the commuter trains are full again and everyone is back in the office. So, it’s time to start thinking about all the things that financial firms need to be addressed over the next few months.
- A number of CCPs have planned upgrades to their margin algorithms which need to be supported.
- UMR may have been delayed for some market participants, but there is still a lot to do even if your timescales have been extended.
- And these changes are happening at the same time as other events such as Brexit and Libor replacement
All this means that margin optimisation should now be considered a requirement if you want to keep making profits in a difficult market. And, with the continued implementation of UMR, suitable collateral to cover margin liabilities is going to be harder to source, so the lower the margin the better.
Upgrades to Margin Algorithms
LCH beat the summer break with their upgrade to IRS margining, bringing the calculation of Unscaled VaR into line with the calculation of the Historical VaR. Now both are scaled from a 5 day VaR to a 7 day VaR for clients. This change had a significant impact on the margin for a number of firms.
CME have their own change to the VaR component of their IRS Margin algorithm coming soon. They are adding an unscaled component, using historical and hypothetical scenarios, to help avoid procyclicality. This will also have the added benefit of allowing them to discontinue pegging the start of their historic scenarios to the 1 September 2008, without losing the extreme moves of October 2008 which are driving the margin for a large proportion of portfolios. In addition, they are adding an Event Risk component which will allow them to cover the risk of specific known events, for example elections.
These changes at both LCH and CME don’t only result in the need for system upgrades. The change in the margin calculated potentially changes the balance for where it is cheapest to clear certain swaps – something worth investigating given the possible savings.
Bigger still are the changes to the ETD margin algorithms that are coming soon at CME and ICE. Both will be moving from SPAN to VaR based algorithms. These are big changes, that will take a large amount of resources to implement. They will also significantly impact the level of margin calculated – for a well hedged portfolio the margin should be lower, but for a directional portfolio it is likely to be higher. These algorithms are also less transparent than SPAN – it will no longer be possible to use a provided Scanning Range to simply estimate the margin on a new trade for example.
And CME and ICE aren’t the only CCPs looking to move away from SPAN. LME, for example, are well on the way to implementing their own VaR margin algorithm. Unlike today, when all the major ETDs (except for Eurex who already have their Prisma VaR based algorithm) are margined using SPAN, each CCP may implement its own algorithm. Firms need to decide how they are going to cope in this new, more complex, landscape.
What’s to be done for UMR?
Just before the ‘summer break’, changes to the timetable for the implementation of UMR Phase 5 were announced. Now effectively there is a Phase 5 for those with AANA over €50bn and Phase V1 for those over €8bn. Now it’s time for firms to put in place their plans for how they are going to meet these requirements. And there is a lot to do.
First there’s calculating your AANA is, and therefore confirming the phase you fall into. Once this is determined, you need to start looking at how you deal with the requirement to post margin:
- Should you be considering clearing?
- If you stay bilateral what algorithm are you going to use (SIMM or Grid)?
- How can you optimise your trades to make best use of the €50m threshold with each of your counterparties?
What about current market events?
If you’re in the UK, all the talk is around Brexit. This is obviously causing some market volatility, but it also raises the question of where is the best place to clear? Now may be a good time to look at any potential savings from moving some of your exposure.
Taking advantage of the cross margin benefits provided by the major CCPs allows savings in margin for the same risk profile. There has already been some evidence of firms using this feature to optimise their margin. Moves in liquidity have been seen between the CCPs, be this additional swaps being cleared at CME and Eurex or an increase in the open interest in fixed income futures on Curve Global.
Libor replacement is also having a big impact on the market. Each of the CCPs is coming up with their own process on how they are going to manage the change in reference rate, particularly the impact on existing swap portfolios. They are also introducing new Exchange Traded Derivatives to support these changes. Again, this could be a trigger for you to check whether it is possible for you to optimise the margin that you pay and therefore increase your return on capital.
Conclusion
So what does this all mean and what are the priorities?
First of all you need to decide what is relevant for your firm and what the impact is going to be:
- Are you using any of the markets where the margin algorithms are changing?
- Are you going to be caught by the next phases of UMR?
- Are you trading products that are likely to be impacted by current market events, in particular fixed income derivatives?
And if you answered yes to any of these questions then you need to make sure that you have all the necessary supporting processes and systems in place, in particular have you got a solution that:
- Supports the upgrades to the CCP IRS margin algorithms.
- Can calculate the new VaR based ETD margin as well as SPAN.
- Allows you to calculate and reconcile SIMM margin requirements.
- Helps you to optimise your margin requirement by, for example, comparing cleared versus uncleared margin, or determining the cheapest CCP for new or existing trades.
