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Firms are continually tested with volatile market conditions
Sustained inflation, higher interest rates and ongoing higher volatility are testing firms’ ability to manage their assets effectively. Managing margin and collateral requirements is front and centre of that challenge.
Volatility has resulted in more margin calls, larger margin calls and greater utilisation of firms’ capital.
Firms that put in place highly automated and optimised processes can not only ensure operation resilience but also, deliver significant funding cost savings. In this article, we establish that even relatively simple adjustments to an automated workflow can have a significant impact.
How have firms been challenged?
The 2022 UK gilt crisis was characterised by the correlated swings in interest rates and debt valuations. This debt-focused maelstrom increased margin obligations whilst simultaneously devaluing collateral balances. The subsequent liquidity squeeze drove a gilt fire sale, creating intense pressure on operational teams to pull back the short securities from their counterparties whilst also managing exceptionally high margin call levels, both in terms of size and frequency.
How can this be mitigated?
As volatility has been persistently higher recently, firms need to build more resilient collateral programs. It is imperative to have a real-time view of your asset holdings and inventory, alongside an automated workflow to seamlessly manage increased call volumes and substitutions that a market event like the gilt crisis requires.
With automated processes in place, firms can remove the operational drag which has traditionally driven many to post their assets inefficiently and can enable significant further gains in resiliency through optimised asset allocation.
To look at this more closely, we examined a newly onboarded client’s gilt pledges prior to joining the service.
To begin, we bucketed the client’s gilt balances by tenor and calculated a volume-weighted sensitivity to a 1% change in interest rates (see Table 1).
Table 1 shows that more than half (54.58%) of the posted assets had a residual maturity over 10 years, and their sensitivity to interest rate change is 5 times greater than the 1-5-year bucket.
A 1% change in rates moved the clients total collateral balance value by 5.3%. If we look at the individual residual maturity buckets, we see that half of the total assets (that can be found within the 10+ residual maturity bucket) drove two-thirds of his 5.3% change. Table 2 sets out the attributed impact of a 1% change in interest rates to the overall collateral balance.
What does this mean in practice?
Collateral balance volatility can put a strain on collateral operations and liquidity. If there is a net reduction in a security’s valuation, not only will the number of margin calls increase, the size of the margin calls will also increase.
Modelling this across the client’s balances, a 1%-change in rates results in collateral balance valuations moving 5.3%.
If that change was an increase in rates, the resulting 5.3% decrease in collateral balances would also need to be offset. That means a greater number of calls as minimum transfer amounts and thresholds are breached and the calls are larger as they need to offset the drop in collateral balance valuation in addition to the trade margin.
If the rates go down, collateral balance valuations go up by 5.3%. Where this balance creates an excess, the principle won’t have access to the capital for three days (allowing time for recall and settlement into the custody account). Should the change in half the agreements result in excess that needs to be deployed elsewhere, it would be an equal value to the FCA’s recently proposed 250bps LDI buffers, i.e. significant to a firm’s overall liquidity.
What action should a firm take?
When firms look to implement a collateral optimisation strategy to mitigate collateral balance volatility, firms will almost certainly need to consider a much broader set of inputs that include the breadth of inventory and corresponding eligibility that firm has.
However, simple measures can be effective.
Table 3 below shows a conservative rebalance of the client’s balances reduce overall duration whilst posting no additional short-dated securities (0-1). The 0-1 bucket is the least correlated to interest rates and is therefore an excellent candidate for our objective. However, due to it also being a priority liquidity reserve, we have elected to post no more in this residual maturity bucket. The remaining three buckets have been posted in equal values, whilst respecting likely concentration and liquidity limits.
This straightforward, conservative approach results in 77bps less volatility on collateral balances, reducing operational stress and freeing up significant capital during volatile markets.
Change does not have to be difficult
With our modern technology and easy onboarding, CloudMargin has helped hundreds of firms get a real-time view of their asset holdings and inventory, automate their workflow and dynamically optimise the allocation of their assets as market conditions evolve — quickly and easily.
