2022 Reflections

The year Liquidity Risk Management mattered

Market Volatility

2022 has been an extraordinarily volatile year. It started off with markets thinking that the big issue was going to be the recovery from Covid and the related supply chain issues. Then Russia invaded Ukraine. 

From the year before, when WTI prices went negative because of the lack of demand, crude oil prices leapt to record highs.

But over the year, it has been the European gas markets that have seen the biggest price changes. Gas supplies between Russia and Europe have been cut and countries are looking for alternatives, in particular importing Liquid Natural Gas. This has put pressure on prices across all types of gas.

The result of this market volatility has been that CCPs have been forced to increase margins, with the initial reaction to the war being a doubling of requirements for Brent Crude. Natural Gas margins were less heavily impacted, with moves of around 40%, but since then this has proved to be the market with the largest increases in margins.

This on its own caused liquidity issues. But in addition, the large price moves resulted in firms having to meet large variation margin calls on the ETD side of hedged positions. However, the profits on the OTC side of the hedge were not available, so firms were left with having to find other sources for the necessary cash.

The additional volatility also impacted the recalibration of the SIMM model used to calculate margin for OTC trades. Usually these updates have little impact on the level of requirements, but with the changes implemented on December 5th, increases of up to 80% have been observed for gas trades.

The European Commision is now planning to implement a price cap on front month TTF futures in an attempt to limit the price of European gas. Both exchanges and industry associations have voiced their concerns about this measure, pointing out that it changes the risk profile of the contract. If this “market correction mechanism” is introduced then it is likely to have a significant impact on the level of margin charged not only on TTF, but also across the whole power and gas complex.

It wasn’t just the commodity markets that suffered liquidity and funding issues. Rising inflation following the end of Covid restrictions led to the end of quantitative easing and interest rate hikes across many currencies. This significantly increased the cost of funding.

But it was the UK “mini” budget on 23rd September that most obviously highlighted the liquidity issues many firms have faced in 2022. The market reaction to the large range of proposed tax cuts was a sharp increase in yields on Gilts. This impacted pension funds, who didn’t have the cash to meet the resultant large variation margin calls on their future positions and were forced to sell Gilts to generate the required liquidity. The Bank of England was forced to step in to buy the bonds and steady the market.

Regulation

2022 saw the introduction of UMR phase 6 at the beginning of September. This brought many new firms within scope and hence put further pressure on liquidity because of the need to exchange margin.

To date, many firms have managed to stay below the $50 million regulatory threshold, but as new trades come into scope additional collateral will need to be available to cover the margin requirements.

In addition, the SIMM recalibration described above has led to an increase in the margin requirement, and will therefore put further pressure on available liquidity.

Crypto

At the beginning of the year, the discussion around Crypto was mainly focused on the high level of margin requirements, not surprising given the price volatility.

Then, in the middle of the year, FTX put forward a proposal for a new clearing model. They were intending to implement real time margin calculations, taking the intra day margin already used by many CCPs a step further. This would have required all market participants to have sufficient liquidity available at all times to meet margin calls.

However, by the end of the year the Crypto market was in disarray. There had been further crashes in the price of a number of crypto currencies, but it was FTX filing for bankruptcy that was the biggest news story. Anyone wanting to trade in these markets now needs to post even more margin.

2023 Predictions

The year Liquidity Risk Management focuses on collateral squeeze

Liquidity Risk Management

2023 is likely to see a real focus on the collateral squeeze. There are many factors that will be making it harder to source the collateral needed to cover margin requirements.

The EU pension fund exemption will expire in 2023, meaning they will be subject to clearing obligations and therefore needing to post margin. In addition, UMR phase 6 will begin to take effect. The slow build up towards the regulatory threshold will continue, with more margin needing to be posted. At this point participants may consider moving some business to clearing. In addition, new participants are likely to be brought into scope as they breach the AANA threshold.

And there is no sign that the current volatility will abate. War is still raging in Ukraine, China is only just starting their exit from Covid restrictions and inflation continues to be an issue across the world. Which means that margins will continue to be higher putting further pressure on the available liquidity.

CCPs

There is expected to be a continued growth in clearing. CCPs are expecting firms who are now paying margin under UMR to look to see if they can reduce their requirements by moving to clearing. This is a distinct possibility given the difference in holding period assumed for OTC versus cleared trades.

The expiry of the European pension fund exemption could also see increased flows towards clearing. This could be the push required for Repo clearing to take off. The solutions have been in place for a long time, but 2023 could be the year when they start attracting business in the same way as swap clearing.

2023 could also be the year for FX clearing. Many CCPs are promoting their services, including introducing new products to cover a larger range of the OTC market. They are also highlighting the potential benefits of clearing, in particular the higher efficiency that CCP margin algorithms provide compared to SIMM.

The pressure on funding costs, particularly with the predicted increase in interest rates, could also see participants making use of the cross-margin services provided by the CCPs. To date, the costs and process changes associated with combining ETD and OTC-Cleared business have been considered too high compared with the margin benefits of combining them under a single margin algorithm. However, the balance has now swung in favour of these facilities.

2023 will also see more CCP moves from SPAN to VaR. Firms will benefit from the more efficient margin calculations, but the analytics required to replicate the margin calculations and provide additional functionality, such as forecast, will become more complex.

Solutions

Liquidity management is going to become more important, and this is going to require solutions that can support it.

Capacity management and limit monitoring are going to be key areas of functionality. Firms recently captured by phase 6 of UMR are using tools to help stay below the $50 threshold and prevent the need for exchanging collateral.

Brokers will need to consider how they allocate limits in view of regulatory thresholds and capital constraints. More sophisticated allocation may be needed, for example based on portfolio level margin impact. And that will require brokers to provide tools to clients, improving visibility on limits and certainty of trade acceptance.

Continued volatility will result in more intra day margin calls, and it’s to be expected that brokers will pass even more of these directly onto clients. This focus on intra day means that all market participants are going to require sufficient liquidity to meet these margin calls – and that will need analytics that allows the optimum level to be assessed.

The cost of funding is already high, and it is expected to increase further over the next year. This makes it even more important that firms are able to minimise their requirements. This will have an impact on the technology required, from more automation, to ever more complex analytics and pre-trade optimisation.

Collateral optimisation will also become more important. There are moves to increase the range of eligible collateral, especially by some of the larger CCPs. The way that collateral is exchanged is also potentially going to change, with more digitised or tokenised collateral being available. Treasury solutions will need to become more automated and include the ability to determine cheapest collateral in a given situation.

With increasing margin and liquidity related costs, firms are going to be looking to make savings elsewhere. This is likely to lead to a rise in the adoption of managed service models, with the best providers looking to include additional functionality, including margin analytics, within their solutions.

Summary

Capital efficiency and liquidity risk management are key themes that need to be on everybody’s radar when planning for 2023.

Increasing interest rates and persistent market volatility will result in higher levels of margin being called at higher funding costs.

On the regulatory front, in-scope UMR phase 6 firms continue to use up their regulatory thresholds and some will find themselves needing to post initial margin for the first time fairly soon. The EU pension fund clearing exemption rules are also set to expire in June 2023 adding to the collateral liquidity challenges real money managers will need to solve for.

In response to various market shaking events that have unfolded this year, we are likely to see a big year for CCPs, with a greater emphasis on the role that clearing can play in the repo, FX and crypto derivative markets.

Ultimately, firms will need to invest in capital and liquidity risk management solutions as a means to build in organisational resilience while minimising the cost of trading.