The sharp rise in market volatility this year has changed how market participants are managing the collateral necessary to back their derivatives trades, according to industry experts speaking at the FIA Asia Derivatives Conference in Singapore this week.
In cleared derivatives markets, the amount of margin required by clearinghouses is tied very closely to the level of volatility in the markets. In a year like 2022 – with huge moves in both commodity prices and interest rates – margin requirements have been much higher than normal. That has put a spotlight on collateral management, a back office function that is now seeing a wave of innovation.
One example is in how clearing brokers are set up to manage margin calls. According to Divya Narula, the head of clearing risk and strategy in the Asia Pacific region for J.P. Morgan, clearing brokers are improving their internal systems so that they are better prepared for the margin calls that come from clearinghouses. Rather than waiting until the end of the day, they are moving to a "much more real-time view" of variation margin moves, she said. And they are more willing to leave some collateral at the clearinghouses as a buffer.
Clearinghouses see a similar trend. Nicholas Steele, the head of rates risk at LCH, commented that he sees a greater understanding on trading desks that managing collateral has an impact on the profitability of trades that are cleared. He pointed in particular to the cleared swap business. Initially, banks and asset managers were forced by regulatory mandates to clear their interest rate swaps, but now the decision to clear those products is more driven by economic considerations – and the cost of collateral is a key factor.
"The need for smart resource management rather than just satisfying mandates is what is driving the economic choice of clearing," said Steele, who was responsible for collateral optimization at Barclays before joining LCH in 2021. "That only works if the back office is fully lined up and can move the collateral around as quickly as possible to make sure they can mitigate the risks and get the best returns for their shareholders. There has been a much greater holistic understanding from the front office now of the importance."
Another factor is the rise in interest rates, which has changed the cost of funding. Erik Mueller, the chief executive officer of Eurex Clearing, noted that interest rate markets are going through a "turn in the cycle" as central banks pivot from many years of very low rates, and said this is drawing attention to the cost of holding cash, bonds and other forms of collateral.
This has had some immediate impacts. For example, in the UK, a sudden plunge in bond prices in September sparked a crisis for pension funds that were using interest rate derivatives in liability-driven investment strategies. The abrupt move in prices triggered large margin calls, which in turn forced these funds to liquidate positions in order to mobilize the collateral needed to meet these calls.
This crisis "crystalized" the importance of collateral management, Mueller said, but the issue goes much deeper. The move to a higher interest rate environment means that "the time when money does not have a price is over," he said. "That focuses minds."
Asset managers and other end-users that use cleared derivatives must be prepared to meet calls for both initial and variation margin, and starting next year, pension funds in Europe will be required to clear their derivatives, he added. These market participants will need to have access to collateral and mobilize that collateral, and Mueller said he expects more innovation in this area in the next several years.
"Process innovation and access to central counterparties is a field that will grab a lot of attention over the next few years," he said.