DerivSource: Derivatives Workflow in 2020

Q: Why is there a need for buy-side firms to make changes to their derivatives workflow? 

Ricky Maloney: The buy-side is having to continually evolve in line with regulatory requirements and cost pressures. 

In the main firms tend  to be reactive in their approach to the required changes in their business models to accommodate these impacts. However, given the plethora of excellent technologies available today, I firmly believe that those buy-side firms wishing to set themselves apart and get ahead of their peers currently have a great opportunity to do so. 

To achieve this they must define and implement an optimal derivatives execution, clearing and funding model – from both a pre and post-trade perspective – taking into account best execution, optimisation of cleared and non cleared and collateral efficiencies by ensuring access to the best technology and leveraging their strong banking relationships. 

Combining pre˗trade excellence with a strategy to ensure the adoption of an optimal derivatives clearing and funding strategy is key. This can be achieved through the allocation of business to the most efficient clearing broker and central counterparty clearing (CCP), knowing at the point of execution the associated financing costs. 

Traditionally, in many buy-side firms, execution and margin cover are done by two different areas: the Portfolio Manager executes and then Treasury covers the margin, meaning many asset managers are unaware of the financing costs of derivatives at the point of execution. Many firms are now starting to look into this more closely.

Q: Why should buy-side firms be improving derivatives workflow holistically now? 

Phil Simons: The Uncleared Margin Rules (UMR) and the regulatory drive to move as much as possible to mandatory clearing are the main factors driving buy-side firms to look at cost and operational efficiency strategies. This year will see a lot more buy-side firms caught by these regulations and this will make it much more complicated for firms to continue doing business in the old way. These regulatory changes are leading to a paradigm shift. Organisational and workflow changes always involve costs. In the past these costs frequently outweighed the gains, but this balance has now started to change. Firms are looking at where the costs are coming from and how they can realise efficiencies. 

The margin financing cost is a significant component. Before they even execute a trade, they need to consider where they will clear it, and how they will collateralise it. Firms need to constantly consider whether to realign their portfolios in a way that allows them to optimize their exposures and get the best use out of their pool of collateral to remain fully vested. It is important to make sure the right collateral is in the right place at the right time.

To do that, they need to look closely at their margin requirements with each counterparty and CCP – from Exchange-Traded-Derivatives (ETD) initial margin (IM) requirements, Over-the-Counter (OTC)Interest Rate Swap (IRS) IM requirements to bilateral collateral requirements. How do new trades impact existing positions? What are their limits, what is the concentration risk and how does this impact liquidity add-ones? Could they do more business at a lower cost and could they reduce the number of margin calls? It is important at this point to look not just at where to clear new trades but also consider non cleared positions.

Buy-side firms can also benefit from analysing whether they can benefit from clearing multiple asset classes together. Although there might not be margin offsets, they might still be able to realise operational efficiencies by using a single pool of collateral. It is also important to look at collateral eligibility schedules. Firms can profit from being able to utilise assets they are invested in to cover margin or assess the cost of collateral transformation. In short, market participants can look at margin financing costs, map that to the collateral in their portfolios, and use it in the most optimal and efficient way.

The other component that needs to be consider is that variation margin (VM) has to be in cash and it could be a pay or receive each day. Hence the cash management treasury function is becoming much more important and can have a big impact on the all-in costs. Asset managers need to look at their workflows so they can make the best use of what they have. It becomes both an opportunity and a threat.

Asset managers need to look at their workflows so they can make the best use of what they have. If they don’t, it can lead to significantly increased costs. It’s both an opportunity and a threat.

- Phil Simons, Eurex

Q: To what extent is the Brexit deadline creating a sense of urgency? 

Phil Simons: The geopolitical situation has created a lot of uncertainty and we probably won’t have clarity for some time. Politicians around the world have made it clear that these decisions are political and will be driven by what is in the national interest. Agreements between third countries are open for negotiation and subject to change in the future. 

Regulators’ and central banks’ main priority is the integrity and stability of their domestic marketplace. The move to mandatory clearing has highlighted issues around concentration and the need to manage potential systemic risks. To minimise these risks, firms located in the European Union, dealing in euro derivatives and repo need to have a clearing capability with an onshore EU27 CCP and to be clearing significant portions of their portfolios there. 

The clear intention of the regulators is to drive as much as possible into central clearing and what cannot be cleared will need to be collateralised. Following the implementation of the European Market Infrastructure Regulation (EMIR) and UMR for standardised interest rate and credit derivatives, regulators will start looking at additional asset classes. They do not want to continue extending exemptions to pension funds or even supranational organizationsand government-owned firms. Future-proofing your business needs a clearly defined strategy that incorporates all of these variable outcomes.

Q: How can building a more efficient collateral management operation help address rising costs and future regulatory and capital requirements? 

Ricky Maloney: In many firms collateral management is still a back-office function and a single view of inventory is not always obvious, perhaps due to their being multiple collateral management relationships. 

Most brokers want high quality government bonds or cash as collateral. Hedge funds can provide cash, but pension funds and insurance firms that are putting on very long-dated swaps tend to collateralise from their extensive bond inventories. Given the average duration and directionality of their swaps, they also tend to need the most collateral. In analysing their portfolios and calculating the lifetime costs of those positions they have the opportunity to ensure that their financing costs are reduced, along with the associated performance drag. In short, are they using the right collateral, and have they done the analysis to see whether providing one bond over another leads to any advantage in terms of costs? 

There are tools to help with such analysis, and I know the buy side is very engaged with providers such as Cassini and Opengamma. For me, all roads lead to best execution and if firms are not calculating the full life-time cost of a trade before putting it on, one could question whether that is being achieved.

For me all roads lead to best execution and if firms are not calculating and proving the cost of a trade before putting it on, one could question whether that is being achieved...

- Ricky Maloney, Eurex

Q: In your experience, are pension funds and corporates doing cross-product margining?

Phil Simons: Many firms are starting to look at this now. They may not have big margin offsets because they might have futures and swaps in the same direction, but it is a much more efficient way to manage their collateral. If they just have one margin call, and one collateral pool covering both their ETD and their OTC, it becomes much more efficient, and therefore much more cost-effective, to manage the financing of those two things together.

Q: Is there a reason that firms haven’t done this until now?

Phil Simons: Historically, all of the exchange-traded instruments – futures and options – have been cleared by brokers through omnibus models. It is only with the introduction of mandatory clearing around OTC IRS that end clients are looking at the level of segregation they have and the degree of protection they want in terms of the collateral they are placing with those clearing brokers. 

More firms are starting to move their futures and options positions into the same segregated accounts that they have for OTC IRS, because they want asset protection on the collateral they are placing for margin, in the event that their clearing broker goes into default. Integration across asset class is a natural evolution in terms of asset protection and margin efficiencies.

Q: What are some of the challenges that firms come up against? 

Ricky Maloney: One of the big issues for the buy side is they still have a large quantity of bilateral inventory. The only way to trade out is to engage the people they put the swap on with. Even if they trade with somebody else and give the original swap up, they are still dependent upon the original counterparty to be part of that conversation.

I am aware that there are firms that can help perform CCP switches,  as well as being able to bring bilateral portfolios into a cleared environment.

Phil Simons:  To help firms address some of the these challenges Eurex has been working with the major trading platforms such as Tradeweb and Bloomberg, as well as the main interdealer brokers Tradition, ICAPand BGC Partners to automate the workflows.

For example, we have been able to automate the exchange-for-swap functionality, where users can simultaneously execute an OTC derivative with a futures contract with both legs automatically cleared at Eurex thus simplifying the workflow, increasing operational and collateral efficiency and reducing costs. All of this helps firms realise the benefits of clearing and meet their best execution obligations. 

Q: What will happen to firms that choose not to make any strategic changes? 

Phil Simons: Market structure is evolving very fast. There is a lot of new technology and more products are going in to clearing. If firms want to realise the benefits, they need to invest and change the way they operate. Historically, companies that were not able to keep up with innovations in the marketplace – in every industry – have suffered obvious effects.

In terms of the financial services industry, whether it is mandatory clearing and collateralisation or artificial intelligence (AI), distributed ledger technology (DLT) or just financial engineering, firms really do have to keep pace.

This article was first published on DerivSource on 10 February.