By Jo Burnham, risk and margining SME at OpenGamma
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, phase 6 of the Uncleared Margin Rules (UMR) 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 related Average Aggregate Notional Amount thresholds.
There is no sign that the current volatility will abate. War is still raging in Ukraine, China is only just starting its 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 available liquidity.
There is expected to be a continued growth in clearing. Central counterparties (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 over-the-counter 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 Standard Initial Margin Model requirements.
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 exchange traded derivatives 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 Standard Portfolio Analysis of Risk (SPAN) to Value-at-Risk (VaR) based methodologies. 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.
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 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.
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.
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