By Ferdinand Peelen – EMEA Director of Sales, Baton Systems 

In March, we were confronted with a stark reminder of the challenges banks face during periods of extreme volatility, as  customers drew down on agreed credit facilities, and risk weighted assets (RWA) and associated capital requirements rose. 

A report by Clarus Financial Technology highlights the significant increase in derivatives margin requirements during March. Most central counterparties (CCPs) reported record amounts in margin calls. CME Base (the core future and options franchise), for example, saw aggregate initial margin (IM) up by $1.7bn to $9.5bn, a fivefold increase on the previous daily record. 

Any volatility-related capital squeeze amplifies funding, market and operational risks. These are existential risks to businesses

Regulators were quick to come to the aid of banks in these exceptional circumstances – for instance, when the Financial Policy Committee of the Bank of England released a statement in which it announced that the requirement for a countercyclical capital buffer would be removed on 11th March. 

While such leniency provides a welcome reprieve,  removing buffers can create vulnerability when there are repeated waves of market volatility – unless, of course, market participants have been able to replenish reserves or de-risk in the meantime. End-Q2 2020 figures around bank credit usage and RWA data will be carefully studied by analysts the world over to get a better understanding of how prepared banks are for further waves of volatility. 

Increasing margin requirements isn’t the only thing to affect market participants during periods of extreme volatility. Bid/offer spreads widen when there is uncertainty and limited risk appetite, which in turn adds to price volatility in a classic vicious circle. 

As this article on Risk.net shows, the cost-to-trade (CTT) of derivatives as a result of wider bid/offer spreads rose across products. For example, in March, the CTT $5m notional in S&P futures increased 107% on average , when compared to a baseline of the three months preceding.

A perfect storm 

With Brexit negotiations nearing their conclusion and the spectre of further waves of Covid-19 on the horizon, market participants find themselves in the path of another perfect storm. Where client firms face a higher cost to trade and soaring margin funding requirements just as they are scrambling to hedge market risk. Where the banks servicing them find their ability to manage value at risk under increased pressure, while they work to accommodate growing demand for intraday financing from clients facing more frequent and higher intraday variation margin calls.

It is likely we will face further bouts of extreme volatility and Baton System’s clients are preparing for this possibility and using the current period of lower volatility to:

  • Manage assets efficiently so that they can be deployed where most needed in times of high volatility 
  • Improve decision making with better, faster data, integrated with eligibility and haircut rules 
  • Eliminate operational hurdles for processing moves; increase capacity by at least 300%
  • Manage liquidity; grow net interest income

Get in touch to find out how we can help you prepare to support your clients when it matters most. 

Referenced sources: