For many years, following the financial crisis of 2008, funding was cheap. Interest rates were at historical lows, at times even being negative. But the impact of Covid, in particular the supply issues as lockdowns were eased, and the surge in energy prices following the Russian invasion of Ukraine, led to a rise in inflation that forced central banks to raise interest rates.

Things were starting to improve, with rates starting to come down. But the continuing geopolitical situation and the volatility caused by Trump’s tariffs mean that the reduction in interest rates has slowed. At the same time the uncertainty combined with regulation means that credit lines and suitable sources of liquidity are harder to find.

This means that making the correct funding decisions is now even more important for Treasury departments in trading firms. They need to achieve the right balance of liquidity risk versus funding costs to suit the risk appetite of the firm. But this is not easy; it requires extensive analysis of potential future costs, including margin, in both the short and long term.

The goal for trading firms is to right-size their funding requirements – setting it too low can result in high funding costs from accessing emergency liquidity, but setting it too high can result in lost opportunity costs. All this is made worse by the level of interest rates, and given the current environment it doesn’t look like they will be returning to close to zero any time soon.

So what exactly do firms need to measure? What are the costs of getting it wrong? What solutions are required to help Treasury departments make the right decisions?

 

What do firms need to measure?

There are two things that firms need to measure in order to make precise funding decisions:

  • Firstly they need to know how much cash they require to cover their funding requirements.
  • Secondly they need to know how that impacts their liquidity requirements. How much could this cash requirement change over a given period of time?

Most firms are using cash to fund margin and this will be the largest part of their cash requirements for trading. They need to know how large their margin is going to be, not just now but also in the future. This needs to take into account what the level might be during times of stress and also how it will change as the portfolio matures.

Sometimes however it is not the level of margin requirements that causes the issues but how much it changes. Liquidity requirements need to be determined based on the size of margin calls, rather than the total margin, over a given period of time. The call will be based on multiple components but the most important are:

  • Variation Margin – the daily profit and loss. It is important to understand how large this could be in volatile markets. Currently most firms are able to use VaR to estimate this.
  • Initial Margin change – rather than the absolute margin requirement. Firms need to be able to assess the impact that volatility will have on Initial Margin but this is not easy to determine because of the complexity of the algorithms involved.

 

What are the consequences of getting it wrong?

There are consequences for getting the funding wrong. There have been plenty of examples over the past few years of large margin calls causing liquidity issues:

  • In March 2022, the Russian invasion of Ukraine led to large price moves in the Natural Gas markets and subsequent Variation Margin losses. At the same time, with price changes often hitting over 10%, CCPs were forced to change margin rates on a near weekly basis.
  • In September 2022, the UK mini budget, which introduced significant reductions in taxation and adoption of radical free market policies, caused significant drops in sterling and increases in Gilt yields. This resulted in large margin calls, particularly for Asset Managers, who were forced to sell Gilts to gain liquidity leading to sudden drop in values, with the Bank of England forced to step in to calm the markets.

In both of these cases, impacted firms found themselves with serious liquidity issues, with some even forced to close positions or remove hedges. For those that survived, the cost of meeting these margin calls was significant. They either had to borrow money at ever increasing rates or join in a fire sale of assets, leading to large losses.

However, too much funding is also expensive. Having a large buffer in place has costs associated with it. Borrowing to fund this or having a credit line in place is expensive in the current relatively high interest rate environment. And if you have the cash available, then not using it for further trading because you are worried about potential future calls is a lost opportunity cost.

Treasury departments need to decide, based on the firm’s risk appetite, the appropriate balance between having sufficient liquidity in place to cover stress scenarios and optimising the amount of over-funding to minimise the costs involved.

 

What is the solution?

Firms need the correct information to be able to make precise funding decisions. This requires a solution that supports the functionality to predict margin requirements in both normal and stress scenarios:

  • Forecast – the solution should be able to forecast likely margin requirements to allow funding to be put in place:
    • T+1 forecasting should use the current portfolio and market conditions to estimate next day margin in time to source the necessary liquidity.
    • Forward forecasting should take a longer term view, predicting margin requirements into the future, taking into account events such as delivery or expiry.
  • Stress Testing – the solution should be able to forecast likely margin requirements under stress scenarios:
    • The scenarios considered could be historical periods of stress or hypothetical scenarios such as a 10% rise in the price of a particular product.
    • The solution should consider the Cash Flow at Risk (CFaR) – the amount of cash that will be required under the stress scenarios for a given confidence level.

 

Conclusion

Determining funding requirements requires complex analysis:

  • Support is required for multiple margin algorithms across all the markets used by the firm. This includes cleared, bilateral and broker specific methodologies.
  • Ability to calculate potential margin under multiple scenarios including historical and theoretical, including taking into account changes in positions.

Firms need to implement tools that support this analysis and give them the flexibility to determine funding levels based on their own view of risk:

  • The solution should allow them to choose the stress scenarios they believe to be realistic.
  • It should also allow them to choose the confidence level that matches the firm’s view of the risks involved.

Only with the right solution will firms be able to balance the cost of funding with  liquidity risk, providing Treasury with the tools required to make precise funding decisions.