23 May 2023

Market movements: No margin for error

Thomas Griffiths
Head of Product

Thomas Griffiths, head of product at Cassini Systems, explores margin and collateral analytics technology and its role in liquidity risk management for derivatives trading.


Due to regulatory reform, most derivatives trades have dealt with the daily exchange of Variation Margin (VM). Still, this requirement too often increases liquidity risk as companies must meet margin calls with high-quality collateral at short notice.

In the last two to three years, margin calls have been severely impacted by market volatility caused by extreme events such as Covid, the war in Ukraine, and, for the UK, the effects of the mini-budget of 2022, which included a severe and quick decline in GBP, against the USD, together with a jump in yields of more than 1.5% in a matter of days.

When writing this article, First Republic Bank (FRB) had just become the second-largest bank failure in US history on May 1, 2023, with most of its business sold to JPMorgan Chase after federal regulators seized it. The bank suffered from a run on deposits just weeks after the collapse of two other large regional banks, Silicon Valley Bank and Signature Bank. All of them had large amounts of uninsured deposits.

While these examples are of sell-side institutions feeling a liquidity squeeze, the lessons are equally relevant for the buy-side. Investor redemptions during stress periods are known and frequently modeled liability risks. Furthermore, the buy-side is a dominant user of derivatives and is susceptible to derivative margins under stress, making them sensitive to extreme market movements on top of their expected redemption profile.

Across the latter weeks of March 2023,  interest rates in some currencies experienced falls not seen in the previous forty years – a sign of panic buying of safe-haven assets that resulted in massive margin calls on interest rate derivatives.

However, the less modeled asset side of the liquidity equation is more in need of attention. The buy-side does not have regulatory liquidity ratios or buffers compared to the sell-side. This means there are likely fewer liquid assets on a typical buy-side balance sheet than a sell-side treasury would have access to.

The risk that the buy-side firms run on their set liquidity profiles was witnessed in the recent UK LDI episode in Q4 2022. As mentioned above, as an effect of the UK mini-budget, some assets lost up to 30% of their value over days due to market swings.

The current macroeconomic environment continues to display a large number of near-systemic events. This means that Treasury and Liquidity managers are closer to market stress that impacts seemingly “safe” assets than they have been during recent history. Liquidity Risk Management is, yet again, getting its fifteen minutes of fame.


The fallout in extreme


According to the Financial Stability Review’s extreme stress testing scenarios (based on Covid models and the 2008 financial crash conducted by the European Central Bank (ECB) in May 2020), over 30% of funds that hold derivatives are highly likely not to be able to meet VM calls under a one-day stress scenario.

This cash deficit amounts to as much as €4.5 billion for a sample of around 3,500 funds. Furthermore, assuming a move to full collateralization by VM, in extreme market scenarios, an added liquidity requirement of about €30 billion for one-day stress scenarios and €70 billion under more prolonged market chaos is needed.

As extreme market shocks and increasing collateral posting are likely to occur — as proven by the past three years — companies are best advised to understand and forecast margin calls under different stress scenarios proactively. Many firms lack the tools to predict margin calls but want to improve this part of the business. The need to better manage margin and collateral resiliency in times of market stress has created a requirement for a sophisticated journey into the technical processes and how to implement these correctly to serve each unique business’s purpose best.

Liquidity Risk Management


The above results strongly indicate an immediate need for liquidity risk management tools for both companies and the broader economy’s advantage in the derivatives markets. The EBC’s report suggests that regulation will also be leveraged to ensure funds can meet possible funding needs resulting from extreme market circumstances. Firms should expect new scrutiny around margin calls and liquidity issues from regulators and must prepare in advance.

Although looking at the asset and liability sides of the equation is a solid start for liquidity management, the real value of liquidity analysis comes from a holistic view of assets and liabilities and their interaction in extreme market scenarios. Liquidity managers should aim to build sufficient liquidity buffers across the organization during stressful events, including all possible stress factors, for example, simulating the timing mismatch between outflows and liquidity-raising capabilities.

In the example of SVB, a liquidity stress test in Q4 last year (upon seeing the early warning signs) stressed deposit outflows over a couple of days. It devalued their ‘liquid buffer’ of US Treasuries in line with expected fed rate hikes, which would have highlighted the liquidity gap.

The lack of adequate liquidity management increases the possibility of funds encountering huge margin calls that cannot be met, resulting in a default on their obligations. Last year, we witnessed a very extreme example when UK pension funds required the Bank of England’s support not to default. Without the intervention of a bank, examples such as this become a systemic risk to the whole economy.

Short notice funding of margin calls also means companies are in a sticky situation: relying on expensive overdrafts or credit. This inadvertently results in increased costs to the business, with prices becoming more extreme in cases where companies have short notice to gather the necessary liquidity.

In the worst instance, substantial margin calls cannot be met, resulting in bankruptcies. One such example is Archegos Capital Management, which announced bankruptcy in 2021, mainly due to it being highly leveraged — a position made possible by meager interest rates at the time.

But all is not doomed. New technology has made great strides throughout the financial sector, and companies can implement margin and collateral analytics to understand liquidity needs better and free up cash. A firm using such intelligent margin analytics can typically save around 30% to 40% of its Initial Margin (IM) requirements. Such analytics can also help firms prepare in advance for extreme market conditions and significant VM calls, avoiding emergency funding’s associated costs.

The future of


In recent years, regulatory requirements such as Uncleared Margin Rules (UMR), extreme market shocks, and rate rises have created a perfect storm for funds, driving up margin calls and hugely affecting liquidity. In the face of this, liquidity management emerges as a frontline response to mitigate potential business woes. An instrumental assessment must look at derivatives and, most importantly, at collateral, allowing businesses to trace a plan for different scenarios.

Higher interest rates make liquidity a more costly problem, resulting in expensive bids to raise cash quickly. Due to this, fire sales become an even greater risk to the business: something only accounting for various scenarios can circumvent.

An essential date for pension funds is quickly approaching — the central clearing obligation under EMIR is due to end on June 18, 2023. The imposed regulation will see pension funds facing increased liquidity risk, including Variation Margin.

The ECB conducted an analysis on liquidity buffers and derivatives exposure on Dutch pension funds and found that the stress testing resulted in VM calls on interest rate swaps being between €36 billion and €47 billion (an aggregate cash shortfall of €6 billion to €15 billion). Using the upper estimate, 55% of pension funds could not fund VM calls.

This sector will likely see an immediate increase in liquidity risk management needs, with funds across Europe unable to rely on banks and solely responsible for meeting funding needs. At a recent Cassini regional event, an adviser from a country bank said to the present hedge funds: “Do not call us. We will not bail you out.” This stance further reinforces the importance of adequate liquidity management.

Liquidity frameworks are essential for hedge funds, which use volatility as an opportunity. Their portfolio strategies consider volatile markets great monetary sources, but this strategy would only succeed with liquidity management. Therefore, proper analytics allow companies to gain a distinct competitor advantage, but only if done proactively and not reactively.

The Framework for


Looking ahead, the most significant challenges financial institutions will encounter over the next few years will be rising rates and their related costs to business due to poor management. Portfolio performances will suffer, especially for hedge funds whose potential trading volume capabilities will suffer due to more margin consumption.

This, in turn, will knock on Prime Brokerages, which will get fewer fees from hedge funds. However, the intelligent prediction of a company’s future liquidity profile results in unique opportunities, including reduced costs and more revenue, resulting in a distinct competitive advantage.

A framework for managing liquidity can be the difference between business risk and opportunity. What we consider necessary is a specific framework around collateral and margin, including intelligent analytics. Transparency will play a vital role in this framework, allowing companies to see across different scenarios and asses where the potential risks lie.

Specific industries have seen frameworks implemented due to regulation, such as the banking and insurance industries, with rules that must be followed. We have seen a growing interest in adopting a framework in markets that are not heavily regulated, but some companies still need to see the benefits of such a structure.

From our perspective, proper liquidity risk management needs to transcend regulation to a more advanced framework, such as one that encompasses the understanding of margin and collateral at pre-trade, enabling decisions on which is the most appropriate trading strategy and one that meets your cash flow.

Stress testing is one of the most common liquidity risk management practices. Still, it is used mainly by large banks that run hundreds of stress scenarios on liquidity, a strategy that has proven to be very effective. Although big institutions in the banking sector do this frequently, the same stress testing and forecasting level only exists across some financial sectors.

Technology companies now make this capability available to smaller players in the industry, and taking advantage of this could be the difference between success and failure.

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