By Ragu Raymond – Director of Business Development and Client Success, Baton Systems
As COVID-19 advanced, financial markets experienced record volatility, resulting in record transaction volumes and collateral pledges at central clearing counterparties (CCPs). While conditions are currently calmer, huge uncertainty remains and further pronounced spikes are a real possibility. But how does this volatility impact Futures Commission Merchants (FCMs)?
Each FCM has its own unique set of complexities, overlaid with the challenges of managing a series of relationships through multiple timezones. The quantum of assets required to support margin requirements has risen dramatically (as shown in the chart below), but this only tells part of the story. Working dynamics for treasury margin teams have been severely disrupted in recent weeks, as legacy processes that depend on a high degree of manual intervention have been tested to the limit.
While huge advances in technology have made remote working feasible for many, working from home reduces normal lines of communication. Even in calmer conditions, treasury desks at clearing firms have their work cut out accessing high quality, up-to-date information on positions, market rates, collateral valuations, eligibility and haircuts – essential for optimising the quantum and construction of eligible collateral posted.
But as multiple platforms and files are required for daily funding information, maintaining control and managing risk across a remote team becomes increasingly difficult, and the inability to share information quickly and consistently leads to further delays and missed opportunities.
Exposing the cracks
While the increased trading activity boosts FCM revenues from clearing fees, fast moving markets increase pressure on liquidity. Periods of market volatility and reduced interest rates are always the busiest for treasury and margin teams and require them to intensify operational efforts; recent months have been an extreme example of this.
Clients’ cash holdings are negatively impacted by the fall in earned interest, leading some to move from cash to non-cash collateral. Each of these changes starts a chain of operational and optimisation efforts.
FCMs and CCPs: It’s complicated
By concentrating processes and relationships around a relatively small set of CCPs, the clearing model provides efficiencies with regards to margin, capital and operations. However, this is a complex set of arrangements, with over 50 CCPs operating in different timezones, communicating with their customers via a range of channels and protocols, and each with their own specific collateral eligibility criteria and processes.
The ability to move cash and collateral when and where it is needed is critical but, with the majority of CCPs, collateral pledges and recalls have to be completed via their dedicated portals. As this process is time-consuming and specific to each CCP, every transfer requires a significant operational effort. This effectively limits the number of movements that can be performed, especially when operations teams are experiencing a generally increased workload.
Other examples of the strains that have been felt include FCMs struggling to keep up with amended CCP haircuts, and client delivery of collateral not being evident to the treasury margin teams in time for the daily optimisation process. Life is especially hard for FCMs who rely solely on end-of-day (EOD) data, even static balances change value materially during periods of volatility.
A number of other functional processes that have witnessed incredible stresses in recent weeks will be tested again during future sustained volatility. These include:
Checking collateral eligibility
Some FCMs do not have sufficient capacity to accurately monitor all of the rules applied by the CCPs on their deposited collateral. It is not unusual for customer collateral that is delivered through to the CCP by the FCM to be rejected due to a breach of these rules. Advice of rejection can be slow and it often impacts a portfolio of moves rather than just a single line. This inevitably results in a strain on liquidity.
Market volatility drives an increase in variation margin (VM) requirements. This is an additional burden for clients and especially FCMs, who usually “upfront” movements to CCPs (paying the CCP before receiving payment from the client), further straining liquidity and reducing Net Interest Income.
As trading activity fuelled by volatility increases, CCP margin requirements for FCMs also rise. To mitigate the subsequent intraday calls, increased excess needs to be held at CCPs, although this puts liquidity under additional pressure as investments are liquidated.
In order to maintain this excess, multiple CCPs will need to be optimised on a daily basis, with substitutions increasing as a result of the strain on liquidity. However, client collateral substitution is not always in line with CCP cutoffs, causing potential lags.
Monitoring changes to haircuts
Sustained market volatility forces CCPs to change the haircuts applied. Collateral eligibility lists will need to be updated to reflect this – yet another time-consuming undertaking.
As we begin to assess the impact of COVID-19, it is important to understand the relative impact of all of the factors that caused the liquidity strain: record volumes, pro-cyclical margin calculations, lack of high quality/consistent data and operational inefficiencies. Did lessons learned from the global financial crisis of 2008 and the subsequent regulatory reforms ensure we were sufficiently prepared for recent events? What further changes are required? Only a thorough regulatory “post-mortem” based on historical data from clearing members will explain what really happened during the extreme market volatility. But it will be no easy task, as members work overtime to gather data for analysis that is not normalised or readily available to them.
Despite our impatience to reclaim our previous “normality”, we are rapidly re-thinking what business as “usual” should mean. FCMs, however, can take action to increase operational and margin efficiencies now, and mitigate future risk by simplifying and streamlining collateral management processes. This is the key to operational integrity, maintaining client satisfaction, preserving liquidity and ultimately driving profitability – regardless of market conditions.
Baton Systems is reforming how payments are made in the world’s largest financial markets. For more information or to arrange a brief platform demo, contact us today.