With the increase in the number and size of margin calls – as well as other financial obligations – speed, automation, visibility and control over cash and collateral is more important now than ever. Why? Because liquidity constraints are increasingly becoming problematic in capital markets.
Take the cleared derivatives markets for example. A small number of well-known financial institutions handle the key "plumbing" of these markets, namely the margin collection and collateral management functions with their clearinghouses. That means they are exposed to large demands for liquidity whenever volatility increases and the clearinghouses step up their margin requirements.
As an illustration, many CCPs increased their initial margin requirements, in some cases by more than 100% when volatility exploded.during March, and customer funds in futures accounts held by futures commission merchants in the U.S. rose by more than $100 billion to nearly $320 billion.
So, if there’s anything that the global pandemic has shed a light on, it’s that during this period of market stress, access to capital is extremely important. The good news is, central banks stepped in to help provide liquidity in the marketplace, at least in the short-term, and the members of the clearinghouses were able to meet the margin calls without fail. But that won't address the urgent need to reexamine the margin collection and collateral management process. The plumbing may not be broken, but it is nowhere near as efficient as it could be.
The underlying culprits are often overlooked — multiple manual processes combined with the lack of consistent, accurate real-time data. These hamper firms from anticipating and meeting margin calls and settlement obligations within very tight cutoff times in an optimized manner. The absence of accurate and timely information means that banks, clearing members and their clients hold large buffers for settlement. In addition to being financially sub-optimal, this practice exacerbates the very problem it seeks to solve by soaking up precious liquidity resources. It also creates operational complexity as clearing firms seek to recall these excess funds, often at very short notice.
However, liquidity is only one component of a complex problem. Lengthy settlement processes and uncertainty about intraday settlement status have been hindering the industry for decades, but the need to tackle this problem is now more urgent than ever. The explosion of volatility in March didn't only result in a huge increase in margin calls. It also generated a massive increase in trading volume, and that made it more obvious than ever that manual processes in the back office simply cannot handle this surge in volumes.
In addition, many clearing members do not have the ability to measure outstanding demand for and obligations to provide liquidity, and to reconcile this against available balances. As such, there is a growing need for systems that can provide a comprehensive view of obligations and exposures across business siloes and orchestrate the settlement of assets in a deliberate and optimized manner.
This is a crucial period for banks and large financial institutions to focus on upgrading their existing systems. However, most financial institutions are reluctant to launch a complete overhaul because clearing and settlement systems are complex infrastructures. Existing “systems” are frequently labyrinthine by nature, comprising multiple layers of data collection and manual interpretation, with processes being run across a diverse range of different and specific interfaces. As a result, most banks have come to the conclusion that it is too expensive and risky to tear them out and replace them all at once. Rather, a better approach is to integrate existing infrastructures with well-tested, secure, new technologies. That will ensure mission-critical workflows can continue without delays or complications.
Firms need to meet their financial obligations, across multiple business silos, in an optimized manner. This can be achieved by aggregating and normalizing multiple data sources, enabling business rules, and integrating with existing payment rails to settle more quickly and more efficiently. This reduces the entire settlement process from days ideally to minutes, and reduces the need to tie up funds in settlement buffers.
By enhancing systems and processes, clearing firms are able to ensure that they can move the right assets to the right place, at the right time, in order to meet their collateral obligations. This positively impacts the economics of the business and the overall liquidity profile of the firm, whilst simultaneously reducing the operational and support burden of meeting and managing CCP collateral obligations.
When it comes to addressing the long-term impact of a global crisis, the end-goal is clear: mitigate risks before another crisis unfolds. In the banking and payments ecosystem, using modern technologies to simplify a sophisticated problem is the best way forward. This is the moment to liberate your balance sheets, and prioritize your next investment.
Arjun Jayaram is the CEO and Founder of Baton Systems, responsible for driving business development as well as planning and implementing the strategic direction of the company. Arjun brings over 22 years of experience as a technology executive at top-tier companies, including Dwolla and Twitter.