By Chris Finger
It has been over three years since the G-20 prioritised the mandatory clearing of over-the-counter (OTC) derivatives. Implementation of clearing mandates has been arduous, but this year has seen mandates go into effect in the US and Japan, and mandates in Europe are likely to follow in the first half of 2014.
While the initial focus of derivatives participants will be on basic compliance, the competitive environment will shift quickly to require more sophisticated analysis. Margin replication will prove to be a necessary capability.
For brokers and investors alike, as clearing mandates start to apply, the first priority will be simply to enable uninterrupted trading and risk management with derivatives. This places the emphasis on operational and legal aspects: for brokers, establishing a client platform; for investors, on-boarding with at least one clearing broker, with the requisite data feeds, documentation, and so on. In the early stages, institutions that can simply comply with the mandates, or assist their clients in doing so, may derive a competitive advantage.
But in the future, derivatives participants will differentiate themselves by their understanding of margin, their ability to efficiently execute derivatives strategies, and their provision of these services to clients.
When an investor clears through a broker, the broker is required to collect at least as much margin as the central counterparty (CCP) would impose. The first question for the investor is a sanity check: does the margin being claimed by the broker tie out with the margin required by the CCP risk model? Is any additional amount consistent with the terms between the investor and the broker? Are there any significant discrepancies that could be the result of an operational error?
As investors consider a new position, they should assess the margin required for the trade alongside the pricing they are offered. Moreover, we anticipate many investors to eventually establish relationships with more than one clearing broker. In that case, would a tighter spread from one broker be adequate compensation for stricter margin requirements?
Beyond the terms offered by clearing brokers, the possibility of multiple brokers and multiple CCPs clearing the same products implies a variety of possible portfolio effects. For a new trade, which broker and which CCP can offer the most opportunity for margin offsets or diversification? As a mechanism to avoid concentration risk, the use of multiple brokers and CCPs is attractive, but does this pose an undesirable cost in terms of lost opportunities for portfolio benefits?
The questions become richer as investors consider not just margin requirements at the trade outset, but how these requirements will change over time. It is easy to appreciate that variation margin (to cover realised price changes) fluctuates daily, but it is important to understand that initial margin (to cover potential future changes) moves as well, even when a set of positions is constant. In some historical cases, initial margin on a fixed portfolio varied as much as four-fold. Investors should plan for this possible fluctuation in liquidity needs.
To address all of these questions, the key capability for brokers and investors alike is margin replication. Without the ability to calculate margin requirements for themselves, in actual and hypothetical scenarios, derivative market participants will be left behind as the rest of the industry moves beyond simple compliance to these more interesting questions of efficiency.
These are not necessarily the questions of today, but they are no longer the questions of some difficult-to-pinpoint future. Market participants need to wake up to this reality, and enable themselves to compete in the new environment.
1. See Finger (2012). Over-the-Counter Derivatives Under Central Clearing, MSCI Market Insight, June.
Chris Finger is executive director of applied research at MSCI
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