Moving from the Margins

Blog posted initially by CloudMargin as part of their Industry Insights Series

Increased use of derivatives and regulatory change is leading to increased focus on how investment managers manage collateral and post margin. 

Brian Dunton, Head of Instrument Engineering

The normalization of derivatives has sparked a sharp increase in their use among investment firms

Among Eagle’s client base of global investment managers, we’ve seen derivatives move from the periphery of the market to become a mainstream investment. Instruments that were once widely considered to be “exotic” are being used by traditionally conservative firms to diversify their portfolios and hedge positions.

A few years ago our typical client trading swaps would hold a handful of positions across a couple of different flavors of derivatives. Now we have clients with thousands of positions spanning many derivative types, each with their own unique conventions. This rapid increase in volume comes with an equally rapid increase in exposure, which has brought efficient collateral management back into the spotlight.

The evolving and fragmented regulatory landscape is contributing to a change in how investment firms manage collateral

Regulatory pressures – specifically the new margin rules for non-cleared derivatives – are kicking in at the same time as derivatives trading volumes increase.

These two factors are coming together to shape how investment firms think about collateral management in three significant ways:

– The increase in volumes and in instruments requiring variation margin has caused our smaller clients to re-evaluate their tracking of collateral. In the past, they may have used spreadsheets and created customized reports. While adequate for small collateral operations, these tools are unable to scale at the same pace as the market. With additional instruments, increased trading volumes, and new regulatory pressures, models involving offline intervention are no longer sustainable.

  •  – Firms tracking collateral manually tend to build in a buffer (over-collateralize) to ensure less frequent margin calls. Over-collateralizing clearly winds up costing the firm money, and as collateral requirements grow these losses will continue to expand. Losses resulting from over-collateralization can go from being a de minimis write-off to a key area of focus. Where many firms were previously satisfied with simply posting and tracking collateral, they are now increasingly focusing on collateral optimization.
  •  – Our clients need to be nimble in order to respond to a constantly changing regulatory environment. This is true across all areas of the investment landscape, but is particularly the case in the derivatives space where the regulatory framework remains fragmented. ESMA, BCBS/IOSCO, the CFTC and the SEC are just a handful of the agencies pushing for regulatory change. EMIR, MiFID II and the Dodd-Frank Act have significantly strengthened regulations in this space. To keep up with a regulatory environment in constant flux firms are looking to be more agile in their collateral management.

Collateral management is moving from a back-office function to part of daily business workflow

Increased volumes, broader adoption of complex instrument types, and constant regulatory change have amplified the importance of collateral management. No longer is it simply a back-office function to be considered only when there’s a break. It is now becoming a core part of the daily workflow for many operations teams. As such we’ve seen a greater focus by investment firms on improving their collateral management practices, particularly through automation in the pursuit of efficiency gains, cost-savings, and greater agility. With more regulation on the horizon and an ever-growing number of instruments available, this is a trend that is only set to grow.

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