TABB Group estimates buy-side firms need to deposit approximately USD2trn in cash and other eligible assets at central counterparty clearinghouses (CCPs) to comply with the new clearing requirement for swaps.
“Capital is a scarce resource that cannot be squandered by overestimating a margin call,” says Will Rhode, director of fixed income research at TABB, who co-wrote “Margin Call: New Risk Tools for the Buy Side,” with contributing analyst Sol Steinberg. “Efficient collateral usage will become an integral, growing factor in a firm’s investment and hedging strategy as improved risk analytics come of age.”
Across 50 one-to-one conversations with US-based asset managers, hedge funds, banks and insurance companies dealing in interest rate swaps (IRS) and/or credit default swaps (CDS), TABB identified industry leaders gaining a competitive advantage by using new, improved back-office technology, specifically risk analytics, collateral optimisation and faster trading processes.
Already doing so, 33 per cent of the firms selected their FCM (futures commission merchant) based on the strength of their technology platform. By integrating with the buy-side’s clearing workflow, the FCM hopes to increase their stickiness and become the primary clearing agent of choice.
Additionally, 80 per cent of the firms calculate their margin requirements based on the CCP price or the CCP’s risk valuation tool. Nearly 40 per cent says they do not validate their margin requirements. In terms of swap portfolio valuations, 11 per cent say they’ll validate their prices against the CCP price; while 22 per cent will rely on the pre-trade, mid-market (PTM) marks provided by dealers. Further, more than 25 per cent of buy-side firms pre-fund their swaps portfolio to ease pressure on internal process. While they do not want to deal with intraday margin calls, pre-funding means there will be less capital to trade.
According to Rhode, the cost of a swap transaction may dramatically exceed the bid/ask spreads displayed in a screen because different clearinghouses charge different margin amounts and accept different types of collateral, each with their own “individual haircuts” and processing fees.
“When it comes to execution, understanding the cost of a swap from a margin and risk perspective is by far the greater concern given the broad disparity in risk calculation methodologies at the clearinghouses as well the sheer variety of collateral types – from cash, to treasuries, to gold, to corporate bonds.”
Based on the interviews with firms representing an aggregate of assets under management (AuM) of USD18.1trn, USD7.6trn (42 per cent) of which is allocated to fixed income, TABB has pinpointed four key trends:
· Straight-through processing of trade execution and central clearing.
· Independent margin calculation and swaps portfolio pricing tools.
· Reconciliation tools accounting for margin call discrepancies.
· Transaction cost analysis (TCA) tools.
The more precise the buy side is in understanding risk, the better it will be at optimising funding, with the potential to repurpose freed-up capital to fund more lucrative trading opportunities. Some are finding that a front-to-back solution is in order, one that covers the entire OTC trade life-cycle, as well as across all groups. Meanwhile, others are stitching together disparate systems from multiple vendor and FCM-provided tools. Those furthest behind the curve are in pure catch-up mode, utilising every available resource just to stay compliant.
As capital gains greater consideration in the months ahead in the buy side’s overall ability to hedge and deliver alpha to investors, TABB sees the rise of the new collateral officer.
“After the execution decision is made, the ability to allocate collateral rapidly and optimise its use will be achieved through a central collateral use decision-maker,” says Rhode.