Non-cleared swaps compression battle heats up

Quantile, LMRKTS, Capitalab and triBalance jostle for supremacy in IM optimisation

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Compress gang: vendors are competing to provide IM compression services

Fintech vendors are competing to reduce the amount of initial margin (IM) dealers must post on non-cleared derivatives trades; though banks caution that some solutions being tabled may prove too complex or costly to merit the investment, and that there is likely room for only one or two to survive.

Quantile Technologies, LMRKTS, BGC’s Capitalab, and Nex’s triBalance have all run dummy and live optimisation exercises with groups of banks in recent months, using multilateral portfolio compression to reduce counterparty exposure and generate IM savings. In some cases, providers claim a saving of 40% in required margin.

Federico Ottaviani, head of the macro capital and funding solutions team at JP Morgan in London, says: “We’re working with providers to create a regular process that can be run frequently. What is needed ideally is an optimisation framework that is robust enough to integrate into the ongoing risk management business-as-usual processes, which can be run frequently without disruption of market-making activity. We’re still some time away from this type of solution, but as an industry that is the goal.”

Initial margining for the largest banks in the non-cleared derivatives market became mandatory in the US, Canada and Japan on September 1, 2016, and for European banks on February 4. Banks are using a standardised initial margin model (the Simm), developed by the International Swaps and Derivatives Association, which breaks margin calculations down into three different risk factors and 12 different tenor buckets, across four separate product classes.

Regulators require IM to be sufficient to cover counterparty exposure over a 10-day holding period to a 99% confidence level – a conservative standard. Vendors are seeking to lower IM requirements with services that tear up offsetting trades and identify new ones, lowering a dealer’s counterparty risk without changing their overall market risk position.

Market participants have estimated IM funding requirements under the regime to be close to $1 trillion, but it is hoped that 50%–70% of that number can be saved through optimisation.

The foreign exchange derivatives market – dominated by short-dated highly standardised products such as non-deliverable forwards (NDFs) and forex options – are a prime target. Though the former are increasingly being funnelled into clearing, a sizable portion of banks’ books continues to be transacted bilaterally.

One of the problems we have with there being a number of contenders for this space is it’s quite difficult to determine which horse to back
Counterparty risk manager at a large bank

The capital manager at one US bank points out that, since NDFs are typically short-dated, most banks will have turned over their portfolios since the IM rules came into force, with the result that the majority of their live trades are now in scope.

“There is not much of a legacy portfolio left, so it makes sense to think about optimisation. Rates products, on the other hand, are much longer-dated, so the piece that is in scope of IM is a fraction of the total portfolio,” he says.

LMRKTS recently ran a series of trial optimisation exercises on NDF portfolios in February with a set of 17 clients in partnership with interdealer broker Tradition. It claims a high success rate: “The savings we showed, applied only to a subset of liquid NDFs, averaged 35%. That equated to $1.98bn of margin reduction,” says Lucio Biase, founder of LMRKTS in New York. On a prior test in 2016, average savings were 43% for the group, he adds.

Nex’s triBalance – a sister service of its triReduce multilateral compression offering – confirms it has also conducted a set of optimisation runs on participating dealers’ forex portfolios already this year, with more rounds planned for rates products.

“Since January 2017 we have had four live optimisation events in the forex space where NDFs were used to rebalance risk,” says Michael Modlock, head of triReduce North America in New York. “We have 27 entities either live or testing. It is still early days but we have already evolved the service to include risk rebalancing for interest rates.”

Capitalab, which has already carved out a niche in swaptions compression, is also piloting forex optimisation: “NDFs and forex delta IM is of meaningful size, and is the simplest problem to solve, so naturally the first solutions available to banks were in that space. Interest rate delta, but also rates and forex vega and curvature components are a chunky piece of the puzzle yet to be addressed, representing over 50% of the rates and forex IM,” says David Bachelier, Singapore-based co-founder of Capitalab.

London-based Quantile Technologies, meanwhile, is aiming to tackle the entire universe of over-the-counter derivatives – cleared and non-cleared – with its optimisation service. It is already leveraging the AcadiaSoft hub – an industry collective set up to help firms meet the obligations of the global non-cleared margin regime.

Quantile uses portfolio rebalancing strategies to minimise concentrations of counterparty risk within the hub. The firm arranges trade execution, with post-trade connectivity and booking offered via various execution platforms, such as Thomson Reuters for forex.

Stephen O'Connor
Stephen O’Connor, Quantile

“What clients don’t want is to have a clunky process that involves doing special data extracts, sending that through email or an FTP, manual execution and booking, as all that stuff is distracting. They want something efficient, straightforward and easy to participate in,” says Stephen O’Connor, chairman of Quantile Technologies in London.

“We are doing a live run every week – real execution with realised savings. In each case the risk reduction and margin benefit has been very impactful. We now have 15 major global banks on our platform,” he adds.

Balancing the benefits

Each of the vendors is seeking to woo dealers with the size of their IM savings, the ease with which their solutions can be integrated into their daily margining processes, the low cost of implementation, and frequency of optimisation runs, each of which can vary by asset class.

“Dealers have to balance the operational lift with the benefits,” says Biase. “From our multilateral calls with banks, the sweet spot, given the average life of an NDF, and the trading volume seems to be an optimisation once every two weeks. If trading volumes justified doing more we could of course do it more frequently with a consortium of banks.”

However not every bank is convinced the implementation efforts are worth the savings.

“Though there are benefits in using third-party compression tools, I think by the time I had done the requisite analysis and got budget approved, many of the in-scope products will be regularly clearing centrally. There are other things I could devote budget to that would be more efficacious,” says John O’Hara, global head of forex prime brokerage at Societe Generale in New York.

Others are taking a wait-and-see approach. The potential margin savings accessible through any one multilateral optimisation platform depend in part on the number of dealer participants, since the larger the risk pool, the more opportunities there are for each to optimise their own portfolio. A counterparty risk manager at a second US bank says it doesn’t matter how smart or efficient a service is if only a handful of banks latch on to it.

However it may take time for a viable leader to emerge from the pack: “One of the problems we have with there being a number of contenders for this space is it’s quite difficult to determine which horse to back. There isn’t enough revenue in it I don’t think for all participants to survive,” the counterparty risk manager says.

Quantile’s O’Connor agrees: “Probably only one or two of us will survive in the long run. Not only is there the cost of supporting multiple firms, but also the fact that dealers might not want multiple versions of scheduling, connectivity, GUI and building of relationships as all of that costs time and effort.”

The counterparty risk manager adds that the potential benefits of tapping an optimisation tool will vary depending on the composition of each dealer’s book.

“Banks with low funding rates, balanced books and lots of client flow would find IM less burdensome than a regional player: one that tends to see the flows go in one direction, tends to face their own domestic clients and lay off that risk to a big warehouse. They might start to see directional biases and have higher funding costs, and start to see bigger benefits from optimisation,” he says.

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