“It’s quiet – too quiet,” goes the line in every Spaghetti Western, when the protagonist rocks up in what looks like a deserted town. Of course, the savvy viewer knows there are bandits holed up behind every window and wagon; by the end of the scene, the set will inevitably have been blown to pieces in a hail of gunfire, with the plucky enforcer, attacked on all sides, needing all his cunning to emerge unscathed.
February 2018 probably felt a bit like this for CME Group. In a month when many of its members faced being caught on the wrong side of the sudden, violent end to the year-long rally in US equities and the accompanying explosion in volatility, the futures market giant was ready. The bourse had spent the preceding months quietly amassing a war chest of $11.6 billion in additional financial resources – initial margin, concentration risk top-ups and extra default fund contributions – which allowed it to ride out the storm.
CME’s actions were a response to its long-held view that equity volatility was not just cyclically low – at the end of 2017, realised volatility on the S&P 500 stood at its lowest since the 1960s – but in fact was being systematically depressed by some of the $1.4 trillion in investor cash pouring into short volatility strategies, in various guises.
“We started looking at the options market back in the third quarter of 2017,” says Sunil Cutinho, president of CME Clearing. “We were of the opinion that volatility was too low – not just stuck in a historically benign environment, but actually being kept artificially low by market behaviour. We observed a self-reinforcing effect, whereby the large number of volatility sellers in the market were continuing to push volatility lower, and driving down implied volatility across the curve.”
Turning its house view into decisive action took guts, though, and a willingness to take a contrarian stance when US equities growth was galloping along at 20% for the year, with implied volatility jammed at multi-decade lows.
In the five months running up to February’s volatility spike, CME upped margins across its equity product segment by more than 20%, including two increases on S&P futures and options margins in January totalling 12%. During January, aggregate margin for equity products as a whole increased by $7.8 billion, or roughly 23%. As calculated stress shortfalls increased, CME also tapped its clearing members, upping the size of its mutualised default fund by more than a quarter to $6 billion.
The increases are only one part of the story, though; ensuring appropriate margin coverage is a CCP’s job. As its concerns deepened early in the autumn of 2017, CME dug a level deeper in a bid to protect itself and its members from what it feared would be an increasingly ugly regime change, ramping up its use of stress testing for individual firms – it stresses some 10,000 large trader accounts among its members every day, regardless of market conditions – and increasing the frequency of conversations with clearing members about their clients’ positions.
The test results enabled the bourse to build up a granular view of short equity exposure across its many thousands of members, down to the portfolio level. In the three months leading up to February 2018, stricter monitoring of those with significant short equity exposures resulted in requests for $2.5 billion in margin top-ups – 225% above baseline requirements – to compensate for what Cutinho and his team saw as the likely increase in the risk of clients being unable to liquidate their portfolios should volatility suddenly increase. The requests were targeted at a broad spectrum of the bourse’s membership, he says, not just proprietary traders and hedge funds.
“If [we have] a concern with a clearing firm’s customer or proprietary positions, we’ll share our stresses with those that are giving us discomfort; we ask whether they’d be comfortable liquidating their portfolio into the market if they had to. That’s a very healthy conversation. The result might be a request for additional margin.”
Margin requirements are no substitute for proactive risk management. That’s essentialSunil Cutinho, CME Clearing
CME’s portfolio-level approach to risk management looks both prescient and proportionate in a year that saw a sole trader on Nasdaq’s commodities market blow through a third of the CCP’s default fund – a trader whose positions the bourse did not consider concentrated, despite the member occupying half the open interest in the spread position, which eventually blew up. CME suffered far fewer margin breaches during Q1 – two, totalling $79 million – than its peer OCC, which suffered 38 at $61.4 million on average, including one of $363 million, and is now reportedly being investigated by US regulators.
The bourse doesn’t want to intercede in the relationship between clearers and clients, says Cutinho; not least because FCMs have far greater visibility into their clients’ positions than one CCP will. “Sometimes, a client’s position with us may be the other side of an exposure – a hedge for something we can’t see,” he adds.
Instead, he sees CME’s role as akin to the market’s sheriff – making polite enquiries as a matter of routine, but taking the direct approach when necessary. “Margin requirements are no substitute for proactive risk management. That’s essential. We get very narrowly focused on the mechanics of margin methodologies – or margin period of risk, or the length of lookback periods. We take a far more comprehensive view than that. Our focus is on early warning and early detection. If we feel certain positions are sensitive to certain stress shocks – and we stress portfolios and clients on a daily basis – and if we feel they could suffer larger losses that could impact the health of their clearing firm, then we talk to them,” says Cutinho.
He declines to comment on suggestions some clients were instructed by their FCMs to close out positions in the run-up to the February selloff – though he does confirm that exposure caps were imposed on a number of clients. These were used to curb the aggregate level of short positions clients could hold at CME and other markets – and again, these were targeted at a broad spectrum of the membership rather than one particular segment.
While many FCMs praised CME’s pre-emptive actions as prudent in prefiguring a period of extreme volatility, not all its clearing members saw the requests for additional margin as welcome. “All that suggests to me is they think their margins are too low to begin with,” says the head of futures and options clearing at one large US bank.
Cutinho believes it is the wrong way to characterise the issue. He argues margin calculations anchored purely to historical information fail to provide a forward-looking view of risk. While historical price moves provide a starting point, other signals such as the participant’s position relative to market size, should also be part of the discussion, he says.
We’ve deviated from our original roadmap on SOFR discounting. It was not a decision we took lightlySunil Cutinho, CME Clearing
“I’d be happy to talk to any risk manager who wants to give me an IM methodology they think is effective in all market circumstances. If they really think that, they need a healthy dose of humility,” says Cutinho.
In the cold light of day, most of bourse’s membership would grudgingly admit it’s not a CCP’s job to do what is universally popular, or listen to those who shout the loudest; its job is to protect its broad membership – and none come broader than CME.
Some cynics suggest dealers’ often very public questioning of CCPs’ margin levels owes more to self interest than genuine risk management concern. A CCP setting lower initial margin requirements means dealers must stump up a proportionally higher contribution to the clearer’s default fund to ensure adequate default resource coverage – a cost of capital they have to fund themselves rather than passing on wholesale to the client. The default contribution is also liable to top up in the event of their being depleted by a default, as happened in this year’s Nasdaq episode.
In aggregate, CME has certainly benefited from the return of volatility to the rates, equities and commodities markets: the bourse looks set to be on track for a huge year for trading volumes, with 4.4 billion contracts changing hands through the end of November, compared with 3.8 billion at the same point last year. To date, 2018 has seen seven of CME’s 10 highest-ever volume days.
Elsewhere, CME has been unafraid to rip up its approach to clearing new products in response to market feedback. In July, Risk.net reported the clearer was set to diverge from rival LCH in its approach to discounting newly cleared secured overnight funding swaps (SOFR) swaps. LCH is set to discount trades at the Fed funds rate, as it already does with US dollar Libor swaps, for several years before switching to SOFR. Following conversations with big buy-side swaps users such as Pimco, CME changed tack and decided to discount the trades at SOFR from the off.
Switching the discount rate at a later date, as LCH plans to, could cause a costly mismatch between the rates that would see one party lose out. As exposures get longer, and potential for the rates to diverge increases further, that pain can become magnified. Those burnt during the switch from Libor to OIS discounting won’t forget the episode in a hurry.
“We’ve deviated from our original roadmap on SOFR discounting. It was not a decision we took lightly. But when we talked to a lot of buy-side firms, particularly those with exposures at the longer end of the curve, they made clear that if we discounted at Fed Funds, they’d be taking a hit, as they did with the switch from Libor discounting. Would it be any less painful for them if we’d switched to SOFR discounting at some point in the future? We felt not,” says Cutinho.
Meanwhile, the group’s acquisitions juggernaut rolls ever onward: its $5.4 billion buyout of the UK’s Nex Group could allow the bourse to bring clearing of every leg of the US rates markets – spot, repo futures and swaps – under one roof for the first time, with the potential to unlock margin savings and operational efficiencies across them. The party line remains that the bourse has no plans to wrest clearing of Nex’s US Treasury and repo platforms away from DTCC for now, though.
And as the year drew to a close, Risk.net revealed the CCP was in advanced plans to switch to a VAR-based clearing model for its vast listed derivatives business – the first of the US futures giants to do so.