Derivatives market participants increasingly know that a better understanding of margin can improve trading activities by reducing trading costs. In a Q&A, Thomas Griffiths, Head of Product at Cassini Systems, explores how intelligent margin and collateral analytics used through the trade lifecycle enhance liquidity management and why this ability is essential with ongoing market volatility. This article originally appeared in Derivsource. 

A: While firms have been concerned with margin calculations for several years, there are three main drivers for firms investing in analytics now. One is regulation, where there has been a significant push towards understanding margin as Uncleared Margin Rules (UMR) have come into force, and firms have grappled with the International Swaps and Derivatives Association’s Standard Initial Margin Model (ISDA SIMM).

For clients that trade cleared and ETD (Exchange-traded derivatives/Futures and Options) products, market volatility – for instance, in the energy sector – is a big issue for our clients. They have seen a significant change in their margin requirements over the last two years compared to the five years prior and feel the cost increases this causes to their business. Firms realize that these situations require better liquidity analytics to understand the drivers of their margin and collateral needs.

Thirdly, rising interest rates and inflation. To fund their margin, firms need to post collateral, and the cost of this collateral goes up as rates increase. This further emphasizes the need to understand your liquidity requirements today, truly, and in the future.

A: Transparency of margin drivers and movements is a crucial step to help reduce the cost of trading. Intelligent analytics help firms understand how much margin they are being charged, why they are being charged, and what they can do to optimise these costs.

Our clients are looking to optimise and reduce their margins using several strategies. This includes identifying risk-offsetting trades they can move between their Futures Commission Merchants (FCMs), or executing more optimal but risk-equivalent contracts on different exchanges. Typically, our clients can save up to 30% or 40% of their IM requirements by efficiently using our intelligent margin analytics.

As well as reducing margin and funding costs, planning well for future margin requirements and collateral requirements can also help reduce the cost of trading. During recent volatile periods, especially in the energy markets, some firms were hit with large variation margin (VM) calls beyond their cash buffers. They had to raise cash using overdrafts or guaranteed credit facilities with high interest rates. In these cases, the true benefit of analytics is being able to prepare for a situation such as this in advance, avoiding the increased costs that come with emergency funding.

Even when cash buffers are not an issue for firms, for example, with large, asset-rich asset managers, reducing the cost of IM can still have a material impact on the business. Reducing funding cost drag on a strategy can mean the difference between ranking in the top 10% of funds within their benchmark range or ranking in the tier below.

Additional benefits include providing transparency on the firm’s liquidity risk and understanding how margin and collateral balances impact the firm’s daily operations. There are also operational and risk reporting benefits, with firms being able to report to their board the possibility of a VM spike ahead of time and ensure they are prepared.

A: Many firms need to ensure their operating model is aligned with viewing and managing margin and collateral holistically.

They often have a collateral management workflow team, a central treasury that manages funding, a derivatives middle office that manages derivatives risk, and risk teams that manage credit risk, but no single team can view all those things in the aggregate to optimally manage their liquidity.

Firms need to think about their operating model and the analytical backbone. When they have separate team setups with different data requirements interested in different functionalities, it can be difficult for firms to aggregate everything—getting a holistic view across the firm, showing where the margin and collateral are essential for operating efficiently.

The most successful firms have bought that information together in a single team to create a center of expertise and supplement this with intelligent margin and collateral analytical software. Without that holistic view and the coordination across departments and desks, it is more challenging to optimise.

“There are four steps to becoming truly optimized: optimizing margin, optimizing collateral, forecasting margin, and generating revenue from your asset inventory.”

A: The main goal of becoming genuinely optimal is cost savings and revenue generation.

To meet these goals, there are four steps on the client’s journey: optimizing margin, optimizing collateral, forecasting margin, and generating revenue. The first two steps help firms understand and reduce their liabilities and understand and utilize their assets efficiently. The third step is to stress test their assets and liabilities to understand how they may behave in the future. When these three steps are followed, a firm can show they have collateral resilience across their firm. When collateral resilience has been achieved, firms can perform various investments and alpha generation strategies with any leftover assets.

So whilst firms can save costs on their margin by optimizing, reducing, and even just by adequately understanding it, their ultimate goal is to get to that fourth stage of the journey – to have enough confidence in their collateral resilience to generate alpha from their inventory.

A: Last year provided evidence that market volatility should be expected rather than a shock and that understanding the firm’s liquidity profile in these situations is essential. That theme will continue this year.

Firms should learn and apply the lessons from last year rather than hoping they don’t see a repeat. Liquidity risk is not going away, and there is no reason a firm will go into 2023 and beyond unprepared.