As the global regulatory storms known as Dodd-Frank, EMIR and Basel III reach the financial community, there is a mad scramble to adapt to the new environment. Perhaps the most critical change is in the area of capital requirements. By some estimates, the new regulatory regime will lead to an industry-wide collateral shortfall estimated from $800B to upwards of $2 trillion.
One recent innovation to help firms efficiently use capital is portfolio margining of OTC derivatives and futures. While most market participants have heard the term, and the phrase has become quite the buzzword at conferences and in interviews, it seems that many do not fully understand portfolio margining, how it works, and the extent of its effectiveness.
John Lothian News Editor-at-Large Doug Ashburn sat down with Laurent Paulhac, senior managing director, financial and OTC products and services at CME Group, to discuss the “nuts-and-bolts” of portfolio margining, why it is important, and how effectively it can reduce capital requirements. According to Paulhac, several of its clients have called portfolio margining “the single most important part” of CME’s overall value proposition.
Q: Portfolio margining has emerged as one of the most prolific buzzwords in the race to offer capital efficiency in the new regulatory regime, but many market participants do not fully understand the concept. What is it?
A: Portfolio margining is the ability to take a diverse portfolio of instruments that are highly correlated, and look at the overall risk on a combined basis, and margin the portfolio as a group. For example, suppose you have a long Eurodollar position that would normally carry a $5 million margin, and an equivalent short interest rate swap position that would be assessed a $12 million margin. Portfolio margining takes into consideration that the overall risk of the position is not the sum of the two, so you would not be assessed the full $17 million. Neither would it be a fully offset $7 million; depending on certain factors, the actual margin would be somewhere between $7 and $12 million.
Q: What types of securities would be available for such margin treatment?
A: We do portfolio margining for a lot of different products. Eurodollars and treasury futures are highly correlated, so we can do portfolio margining across those interest rate instruments, as well as in our interest rate options complex. We also do it for highly correlated commodities products, such as WTI, Brent, and DME Oman Crude contracts, as well as natural gas.
This is not a new thing. We have done this for years in the world of futures. What is relatively new, though, is the ability to offer portfolio margining between futures contracts and OTC cleared swaps. A swap dealer, which is essentially a liquidity provider for swaps, will, as soon as it makes a trade with a client, be looking to offset the risk of the position in the inter-dealer market, either with another dealer or, as is often the case, by using Eurodollar futures. For that particular firm, portfolio margining is very attractive, as it substantially reduces overall margin cost.
Q: I began trading CME products in the early ‘90s, just as SPAN was becoming the standard for margining listed derivatives by VaR (value at risk) modeling. Is this just an extension of SPAN?
A: It is similar to SPAN, but separate. Interest rate swaps are margined on an HVaR (historical value-at-risk) basis, with a 5-day margin period of risk (meaning the market holds enough margin to cover a 5 day liquidation period under a default scenario). Eurodollars, and other futures products, are margined on a SPAN basis, which assumes a one-day liquidation period.
So, suppose a client wants to take advantage of portfolio margining between, say, a swap and a Eurodollar. What the client will need to do is take the futures position out of the 4(d) account, which is a “commingled” futures account, and place it into a separate, “sequestered” OTC account. When the funds are moved, we will recompute the margin requirement using HVaR. We will then apply the algorithm to understand how these risks offset each other, to determine the total margin required. The margin requirement will be much less.
Q: But, in your example, when you move a Eurodollar position out of a futures account and into the sequestered account, you move it from a one-day to a five-day liquidation. Wouldn’t that increase margins?
A: Technically, yes, but since the margin offset with the swap is much greater than the additional margin required by the future, the total margin required will be substantially lower than if they were margined independently of one another.
There is an additional benefit, too, especially for clients interested in customer protection. Once the futures are removed from a commingled account and put into the sequestered OTC account, it follows LSOC (“legally separated; operationally commingled”) rules, which are still commingled, but with additional operational and reporting rules overlaid to them, effectively adding more client protection.
Q: What number would you offer in terms of collateral efficiency? I have heard it is about 75 percent. Is that about right?
A: It all depends on the portfolio of course. It could be anywhere from 65 percent to 85 percent. It will never be 100 percent – a treasury future is not a swap and a swap is not a Eurodollar.
We have made portfolio margining available to the house accounts, effectively the banks’ accounts, since March of last year. Some firms have been able to take advantage of it, but the others have been so busy building their client clearing infrastructure that they have not had the resources available to focus on that quite yet despite the benefits. As an example, one of the firms that has taken advantage of portfolio margining has already saved about a billion dollars in margin.
For customers, it is a little more complex. We rolled out the infrastructure in November 2012 for clients to take advantage of portfolio margining, but they cannot participate until their clearing members have completed the technology and operational investments to make it work in a scalable format for clients. On March 11, we announced that the first client, Capstone Financial, and Barclays, its clearing firm, completed portfolio margining for the first time at CME, for interest rate swaps and futures. It was a groundbreaking early-stage effort, and now clearing firms are working to fully industrialize the process. We hope by May 2013 a few clearing firms will be ready with a full solution.
At our Information Xchange panel at the FIA Boca conference, we had a discussion with Richie Prager, head of trading at BlackRock. He said that the “nirvana” for them would be to be able to do portfolio margining between interest rate swaps and futures, and also with cash treasury products. We have two legs of the stool, and we are always looking at ways to create even more value.
Q: How does this work in conjunction with portfolio compression exercises? I would imagine you would first compress anything you can, and extinguish as many swaps as possible, and then portfolio margin the rest.
A: Exactly right. Portfolio compression is really taking the net risk and reducing the number of line items for OTC swaps. The risk of your portfolio is not going to change with compression; it is just going to simplify the number of line items. Once you have done that, you are able to start moving the appropriate futures positions offsetting the balance. You will not move all of your futures book; you are going to pick and choose those that best offset the OTC positions and result in aggregate lowest margin.
We have developed a tool called the Optimizer that analyzes an OTC and Futures portfolio and tells you exactly which positions to move. It is a proprietary tool that we offer to our clients to make it easy for them to take advantage of portfolio margining.
Dodd-Frank is introducing a lot of new costs. We continuously hear talk about the negative impact of total cost of clearing. There are trading strategies that are likely going away because what may have been a good strategy pre-Dodd-Frank may not make economic sense now. The number one cost increase is probably going to be margin, which is why we are so focused on portfolio margining.
Laurent Paulhac is senior managing director, financial and OTC products and services at CME Group. He joined CME Group via the 2008 acquisition of Credit Market Analysis (CMA), a provider of credit derivatives market data, and at which Paulhac served as CEO. Though CMA was sold to McGraw-Hill in July 2012 as part of the deal that created S&P Dow Jones Indices, Paulhac remained with CME Group to spearhead the firm’s expansion of OTC derivative offerings.
For more information on portfolio margining at CME Group, click here.