As hedge funds continue to increase investments in non-traditional asset classes and regulations continue to tighten, margin requirements and balances have increased to new heights. With the Uncleared Margin Rules (UMR) requirements, firms phasing in to UMR have now posted increased amounts of collateral. According to ISDA’s 2023 year-end survey, a $1.4 trillion margin was collected across initial and variation margin, including a 47% increase of regulatory initial margin collected compared to year-end 2022.1

Hedge funds faced with the age-old debate of continuing to rely on counterparties for margin calculations vs. replicating their margin requirements in-house now have another reason to invest in in-house calculators across house, exchange, and regulatory margin methodologies. While previously the impetus for replication primarily focused on mitigating counterparty risk and clawing back excess margin for its opportunity cost, our evolving markets have now introduced risk management and collateral efficiency considerations into the equation.

Maximize operational processes

On April 17th, the Financial Stability Board (FSB) published a consultation report2 calling for higher levels of liquidity preparedness for margin and collateral calls amongst non-banking market participants. This report highlights many benefits of internal margin replication and underscores the risks of failing to do so. Any firms that are not replicating their own margin are quite literally leaving money on the table, increasing their counterparty risk, and gambling with financial stability.

With that in mind, here are the top 5 reasons to replicate margin:

  • Reduce counterparty risk and exposure by clawing back excess margin otherwise locked up as collateral
  • Unlock the value of unencumbered cash by sweeping it into overnight funds to capitalize on higher interest rates
  • Empower funds to bring margin-efficient managers onto the platform by tracking individual margin consumption
  • Enhance capital allocation across strategies and managers by leveraging margin as an additional input to the decision-making process
  • Improve the financial stability of the firm by enabling more effective liquidity risk management governance, creating robust stress test scenarios, and streamlining the collateral management workflow

Evaluating counterparty risk

If 2008 taught us anything, it’s that holding too much cash at one counterparty can put your firm at high risk should they suddenly become unable to return that collateral. Since our markets are evolving, with transaction volumes and position sizes both increasing, it is easy to presume that the large amount of margin being called by counterparties is correct. However, in the event that counterparties are overestimating the amount of margin required, investment firms have excess cash locked up that could otherwise be clawed back to reduce that risk.

Holding excess cash at a counterparty also presents the opportunity cost of short-term interest. With our steadily rising interest rates, that opportunity cost continues to grow. The power of understanding the exact margin requirement per transaction repositions firms to increase their unencumbered cash, reinvest it in other strategies, or sweep it overnight to capitalize on these rising short-term rates.

Although these arguments do present a strong case to replicate margin and claw back your excess, the FSB consultation report also introduces an interesting concept, encouraging hedge funds to improve their liquidity risk governance process and increase collateral management efficiency.

Given the 2020 market turmoil, the Archegos failure in 2021, the commodities markets turmoil and the pooled liability-driven investment fund issues in the UK in 2022, the FSB has decided to speak out. On April 17th, the FSB published a set of eight recommendations for hedge funds that outlines various measures to be taken to improve market stability. These recommendations support improving liquidity risk management practices, enhancing stress testing and scenario design, and optimizing collateral management processes to reduce impact to market participants in times of stress.

RELATED READING: Is Your Firm Regulation-Ready?

Summary of the FSB recommendations

#1-3: Liquidity risk management practices and governance

  • Outlines the need to broaden governance frameworks to include liquidity risk that arises from sudden spikes in margin and collateral requirements.
  • Establishes the importance of setting liquidity risk appetites and creating contingency funding plans to ensure that even under volatile market conditions, liquidity requirements can be met.
  • Once established, these frameworks and processes should be run and reviewed frequently to ensure continued mitigated liquidity risk during times of stress.

#4 & 5: Liquidity stress testing and scenario design

  • Liquidity stress testing should be comprehensive and frequent, with the tests specifically designed to identify potential sources of liquidity constraints and ensure that sufficient and diverse sources of collateral are available.
  • Stress tests to cover a range of “extreme but plausible scenarios” including historical as well as hypothetical assumptions.

#6-8: Collateral management practices

  • Highlights the need for efficient and operationally optimized collateral management practices.
  • Underscores the need for hedge funds to have a sufficient amount of cash and diverse liquid assets readily available to deploy as collateral, particularly during spikes of margin requirements
  • The FSB urges “active, transparent, and regular interactions with counterparties” in transactions and positions with attached margin requirements.

How to address the FSB’s margin replication concerns

The best way to address these concerns is to replicate your margin in-house. The most effective way to optimize treasury operations is to understand precisely what the options are, and the best way to do that is to take back control over your data.

Accurate in-house margin replication places the power of the margin call back into the hands of the manager by predicting the margin calls before they are received and enabling them to estimate the margin impact of upsizing or downsizing existing positions. Decisions around capital allocations and portfolio manager onboarding can be bolstered by tracking margin usage by manager and leveraging margin as an additional variable in the decision matrix. Firms can increase transparency and trust with their investors by providing true performance updates of their funds after incorporating cost of capital.

While counterparties may run margin estimations that call for a certain amount, hedge fund managers may find that their own calculations reveal a lower requirement. Precise in-house calculations give managers the ability to dispute these calls, resulting in excess margin that can be clawed back. Clawing back this excess margin reduces counterparty exposure and thus counterparty risk, empowering treasury teams to improve the financial stability of the firm.

The aforementioned opportunity cost is also a significant factor. Mortgage rates exceeded 7%3 in the fall of 2022 for the first time in over 20 years. By the end of 2023, interest rates were rising at a faster pace than we’ve seen since the late ‘70s4. With rates remaining elevated, the benefits to reclaiming unencumbered cash are clear – portfolio managers can deploy this cash into other investment opportunities, or the treasury team can simply sweep it into overnight funds to capitalize on the higher short-term rates.

RELATED READING: Preparing for Uncleared Margin Rules

Liquidity risk and financial stability guidance

Now, we must also consider the guidance presented by the FSB to improve liquidity risk and financial stability. Liquidity risk management practices are only as robust as the data being fed into those frameworks. A holistic view of position movements and potential impacts to margin will drive the quality of these new governance practices, as will a firm grasp of cash balances and the margin movements that drive them. Firms must have an accurate representation of which movements within their funds will cause large spikes in margin and collateral requirements.

Adequate stress-testing is also impossible without precise margin replication. These calculations shed light on when these requirement spikes could occur, and they outline mitigation practices. Having unconstrained transparency into margin requirements enables firms to build their own “extreme but plausible” scenarios to run through their margin calculators. Any lack of precision amongst these stress tests renders them all but useless in the face of actual market volatility, and leaves managers unprepared to provide sufficient liquidity.

Collateral management practices

The final piece of the FSB guidance is efficient collateral management practices. A margin tool with replication that is fully integrated with collateral management workflows, including wires processing, streamlines collateral management. This provides communication transparency across internal teams and gives firms the ability to quickly react to market demands.

To enable those “active, transparent, and regular interactions with counterparties” that the FSB inspires, it is critical to have all appropriate information at your fingertips. Without an independent view of margin requirements and their drivers, it is not possible to have a transparent conversation about collateral calls. Beyond disputing individual calls with counterparties, replication and what-if margin analysis also provide the opportunity to test moving positions around counterparties to optimize margin requirements, even further reducing the liquidity strain on hedge funds.

The responsibility of effective margin management does not only lie with the treasury team, but also with the front office making investment decisions. Currently they may be making investments based on vague assumptions around margin requirements. Much of the work of the middle and back office can be further streamlined if the process of margin management starts with the portfolio construction. Having the ability to integrate margin replication with upstream tools via APIs or direct integration empowers PMs and traders to make more margin-optimal decisions.

Considerations for a margin replication solution:

  • Variety of supported agreement types
  • Ability to support UMR for regulatory initial margin
  • Modern technology stack for API accessibility and integration opportunities

A margin replication solution

A proper margin replication solution will not only support all the considerations mentioned in this article but will also be comprehensive enough to future-proof your firm against any additional requirements. Accuracy for margin replication is critical, but it only goes so far if the solution can replicate just a limited number of agreement types. Agreement-type agnostic solutions that encompass house, exchange, and regulatory margin give hedge funds the opportunity to set up these governance structures for current and future asset classes.

The solution should also keep up with today’s regulatory requirements, including UMR. ISDA has certified several vendors as verified SIMM calculators, so funds can grow without the concern that they will lose control of their margin processes upon reaching a certain notional with their counterparties. Any firm that has a vendor solution without approved SIMM calculators will face another vendor-selection process once they reach a certain amount of growth. This can increase the total cost of ownership, potentially beyond the value saved with margin replication from the start.

With additional technology also comes the question of data accessibility and the possibility of integration. Margin replication solutions with API accessibility spread information on margin requirements across other platforms in the technological infrastructure. Platforms with API accessibility to margin simulations elevate your firm to a higher level of risk management. API accessibility to margin what-if analysis brings these optimization decisions into the portfolio construction and trade simulation process. Together, this unlocks front-office use cases to compute margin on theoretical portfolios and ensures alignment across the enterprise.

Can Arcesium help?

Of course! Our industry-leading margin calculators were built with our in-house industry experts and are completely agreement-type agnostic. These calculators provide a daily view into position-level margin, empowering firms to optimize their margin utilization and take control of their disputes with counterparties. Our clients typically claw back an average of ~$6.5 billion per year in erroneously called margin. Our team of industry experts who can be engaged to act as an extension of our clients’ operations teams have a 95-98% success rate in UMR-specific disputes.

The granular view into margin and its drivers also sheds light on drivers of specific margin penalties, down to the individual securities. In 2023 alone our clients saved ~$2 billion in margin penalties through our optimization dashboards.

Beyond the status of “what is” with margin replication, we also provide margin simulation abilities where clients can run thousands of daily what-if analyses on existing or hypothetical positions, with production or hypothetical margin calculators. This helps our clients understand potential impacts of certain transactions or position movements. This margin simulation tool has full API accessibility, providing the freedom and flexibility to deploy these capabilities across the investment management lifecycle.

The path forward

To learn more about margin replication and other ways to maximize your operational processes, download our whitepaper on Creating Efficiencies for the Middle and Back Office.

Author:
Rochelle Glazman
Rochelle, Head of Product Marketing, is responsible for the Product Marketing function at Arcesium, enabling go-to-market and growth strategies across sales, marketing, product, and client engagement. Before taking on this role, Rochelle was a Senior Pre-Sales Consultant, engaging with clients and prospects across the financial services industry. Prior to joining Arcesium, Rochelle spent over five years at BlackRock Aladdin servicing institutional asset managers and leading several implementation projects across North and South America. She graduated from Vanderbilt University with a degree in economics.

Sources:
1 ISDA Margin Survey Year-end 2023, ISDA, April 16, 2024
2 Liquidity Preparedness for Margin and Collateral Calls: Consultation report, FSB, April 17, 2024
3 U.S mortgage rates soar to highest in more than 23 years, Reuters, October 25, 2023
4 How to take advantage of the highest interest rates in decades, CNBC Select, November 16, 2023

 

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