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June 10, 2013 12:21 pm
One of the trickiest issues banks and brokers will face in coming years is finding the collateral, or insurance, they need to back their trades.
All recognise they will need more for trading when the wave of competing financial services regulation kicks in; few know how much will be required, nor what will be acceptable to both regulators and clearing houses.
As customers face this unanswerable question, market infrastructure operators are turning to technology to find creative ways around the problem and more accurately measure the daily value of the margin investors put up for their derivatives trades.
As futures and options contracts are open-ended over months and years, this type of risk management affects all areas of the trade cycle.
For example, a clearing house has to calculate initial margin for a derivative based on potential movements of its underlying price and volatility. The impact of time is a key factor in the valuation of an option. In both cases, the clearing house needs to calculate an initial margin valuation that will cover the repurchase of a failed portfolio while also absorbing its loss.
For some, such complexity means engaging with the 21st century. At a collateral conference organised by Trade Tech in London last week Andrew Howat, group head of collateral and liquidity management at LCH.Clearnet, said there had been some major upgrades in the industry in the last two years. “It was only 18 months ago some dealings were done by fax,” he said.
However, this transition is more of a series of smaller steps, rather than a sweeping gesture. In part this is due to the singular nature of local jurisdictional rules. It may be a quiet revolution but it may be equally profound. Three recent developments have underlined this trend.
Take Nasdaq OMX NLX, the world’s newest derivatives trading venue, which launched at the end of May in London trading listed fixed income products. One of its distinguishing features is an agreement with LCH.Clearnet to calculate the amount of margin traders need based on a methodology known at Value at Risk (VAR).
While fairly common for banks to use VAR to calculate the risk of a swaps portfolio, it is a significant departure for the listed derivatives industry, which largely uses a 25-year-old methodology known as Span. Var is a more complex calculation but its advocates say a more accurate number potentially stops traders from posting more margin than necessary.
Detractors point out that VAR has its flaws, particularly in stressed conditions, but at present global authorities prefer VAR as a methodology to measure risk.
“Regulatory change is driving the need for us to look closely at how we create capital efficiency in all parts of our business,” acknowledged Adrian Averre, global head of G10 flow rates trading at BNP Paribas, at NLX’s launch. He spoke of the potential “significant margin savings in the short, medium and long-term”.
Elsewhere TradeWeb, the US fixed income trading platform, has followed companies such as Traiana, Markit and ICE CreditLink, in creating a credit checking hub for derivatives trades. Part of the service meets incoming regulatory requirements under the Dodd-Frank Act, by which all parties have to be notified electronically of the trade. It also is likely to speed up a process that, because the trade was conducted over the telephone, previously had to be put on to a spreadsheet manually.
Finally, last week TriOptima, majority-owned by interdealer broker ICAP, extended its links with the Depository Trust & Clearing Corporation of the US to help market participants more accurately monitor portfolios containing OTC derivatives.
This link takes the numbers registered at a DTCC’s trade repository – one of the new data warehouses required by the G20 to store information about all the world’s off-exchange trades – and reconciles it with an investor portfolio.
Unlike the credit hubs, the TriOptima-DTCC was not directly in response to a regulatory requirement. Nonetheless, it is a sign market participants are considering new ways and links to make incremental savings.
And it is clear the market is responding to these moves. Markit, the UK data provider, said last week it had signed up BofA Merrill Lynch, Citi and Goldman Sachs as the first futures commission merchants to use its OTC derivatives credit hub, run by its MarkitServ unit.
Nasdaq has a host of banks and electronic market makers on its platform, such as BNP Paribas, Citi, Nomura, DRW Trading Group, Getco Europe and Newedge using its platform.
But this drive has other consequences. “The problem with VAR is that it is a black-box technology, meaning it requires spending on other technology such as middleware,” said the head of clearing at one global investment bank.
The second is that this change is pushing more of risk management, and the tools that underpin it, on to third-party infrastructure providers like exchanges and data providers. That in itself is changing our understanding of what these companies are. The question will be whether they can make the vision work coherently.
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