THE REGULATORY BACKGROUND
The modern regulatory environment for OTC derivatives is shaped by prudent risk management to protect the market against defaults. This agenda has been promoted by three main policies:
- A requirement to book trades through a central clearing counterparty wherever feasible. This amounts to a clearing obligation (CO) for vanilla products.
- A range of policy movements that encourage portfolio compression. Basel III liquidity requirements provide a driving motivation as they are based on gross notional positions rather than net positions, which promotes gross notional compression. In addition, the European Market Infrastructure Regulation (EMIR) has an explicit bi-annual requirement to compress a portfolio of more than 200 contracts.
- The phasing-in of non-cleared margin rules (NCMR). The initial margin (IM) calculation is designed to be higher than a central clearing counterparty’s IM requirement. This reflects the higher risk of a bilateral trade and encourages participants to use a cleared route where possible.
THE OTC MARKET RESPONSE
OTC derivatives markets have successfully risen to these challenges by the widespread adoption of technology-driven solutions that have made OTC products keenly competitive against exchange-traded derivatives, whilst maintaining the attraction of their contract flexibilities.
The third-party, specialist risk reduction service provider plays a decisive role in maintaining OTC competitiveness, whilst simultaneously protecting the market against systemic counterparty risk.
Capitalab is an industry-leading service provider. Both margin optimisation and compression work best when applied to as many potential trades as possible. The key to our success is a combination of:
- Advanced algorithms that can deal with the widest range of linear and non-linear products
- A deep liquidity pool with multiple large-scale participants
INITIAL MARGIN OPTIMISATION
The phasing-in of the NCMR across jurisdictions since 2016 is bringing an increasing number of derivatives market participants into scope. There is now a widespread need for better management of initial margin that expands far beyond the major broker-dealer banks.
The identification of IM is a risk-based calculation that can be an extremely resource-intensive process. Central clearing counterparties (CCPs) each use a proprietary calculation model. The bilateral OTC market has coalesced around the ISDA’s standard initial margin model (SIMM) methodology. A proprietary SIMM IM model will be constantly assessed by counterparties and regulators. It will need constant updating and back-testing. For most participants, a specialist service provider is best placed to run these calculations.
Obviously, this onerous management process can be avoided by choosing a cleared trade route, but many trades – such as swaptions, cross-currency swaps and most non-deliverable forwards (NDFs) cannot be centrally cleared due to their tailored features.
Capitalab – with its advanced algorithms and access to an OTF and LCH, is able to optimise cleared and non-cleared portfolios simultaneously. Capitalab minimises IM costs by running multilateral optimisation between numerous counterparties. This powerful process saves margin costs and reduces collateral and capital requirements.
Compression is a process that identifies offsetting positions and reduces them to capture the net position, leaving the market exposure unaltered whilst reducing the gross outstanding.
The practice originated with bilateral book compression between major sell-side dealers. Multilateral compression by third-party vendors has greatly increased the potential scope and efficiency of the tool. A risk reduction service provider has access to multiple dealers. This large liquidity pool of similar products offers potentially far greater opportunities to reduce each participant’s gross notional exposures. The service provider runs a periodic offsetting run between multiple participants, which is called a compression cycle.
Compression is most complex with OTC derivatives, where even vanilla products will have various payment dates, so multilateral compression is the best solution to find matching dates. It is particularly challenging to be able to compress tailored products such as swaptions, caps and floors, and FX options. Capitalab specialises in compression of these complex products.
The combination of these technology solutions has contributed to a significant reduction in systemic risk across OTC and cleared derivatives markets, whilst simultaneously increasing trading cost savings and reducing counterparty risk exposures for each client.