LCH’s SwapClear is set to make a significant change to its initial margin policy later this month by making it easier for buy-side clients to post excess margin against their positions. The move is aimed at preventing clients with large directional portfolios being outsized contributors to a futures commission merchant’s (FCM) total margin contributions, reducing the funding burden this places on the bank.
The changes, which should go live on or after March 27 pending regulatory approval, will allow buy-side clients to systematically over-collateralise positions above their baseline initial margin (IM) requirement to a level they would expect to face during a stress scenario – for instance, by pledging otherwise dormant assets held in segregated accounts as margin.
The central counterparty (CCP) already allows clients that are major contributors to an FCM’s total margin contribution on any given day to over-collateralise – a policy it implemented in September. But the rule-book change will allow clients that are big contributors over the period of a month to opt into over-collateralising on a systematic basis.
Clients can opt in and out of the scheme every 30 days; but once they elect to over-collateralise on a given month, they are compelled to observe the policy. The scheme is voluntary for clients, although FCMs may choose to incentivise those customers that typically make up the largest part of their net margin contributions to take up the service through favourable pricing.
The head of derivatives at one UK investment manager says his firm has discussed the issue of pre-funding IM requirements with its clearing broker, acknowledging that such moves will help alleviate the funding burden that meeting clients’ margin contributions places on banks. But he adds that, as a largely directional player, the cost of over-collateralising its trades could become “significant” as its cleared positions mature over time.
“I fully get and understand why the CCPs and clearing members want to do this. We’ve already been having conversations with our clearing members where they say they would like us to pre-fund the IM on our accounts up to the clearing limits that they’ve given us. But it’s difficult to assess the impact without knowing the quantum of the numbers. We’re directional in a lot of what we do, particularly for our in-house clients. It’s the nature of the business: we are pensions, long-term investments,” he says.
The changes have been in train for roughly two years, but are fortuitously timed: two FCMs say the scheme should help reduce intraday funding stresses posed by outsized margin calls on days of market turbulence – an issue that came to the fore in the aftermath of the UK’s vote to leave the European Union in a referendum last June. LCH’s margin policies came in for criticism in the aftermath, with some accusing the CCP of being overly conservative and too slow to return collateral to FCMs.
LCH makes up to three intraday IM margin calls – dubbed market data refreshes – requiring clients on the losing side of a trade to top up their IM quotient. Clients with large directional interest rate swap portfolios – for example, fund managers running liability-driven investment strategies – are the most exposed to sharp intraday moves in interest rates, such as those which followed Brexit or the US elections in November. Even if interest rates subsequently snap back, as they did in both of those instances, the intraday calls must still be met, with margin tied up in secure investments.
But clients such as liability-driven investment managers also tend to be flush with high-quality liquid assets such as government bonds. The rule-book changes will allow clients to assign a lien over the assets to the CCP or its FCM, allowing them to recognise the client’s account as over-collateralised, and negating the need for the FCM to fund the client’s intraday margin call if the market moves against them.
LCH is planning further changes to its margining processes in a bid to target intraday funding squeezes – but it has previously trailed the over-collateralisation policy as part of the solution to the same problem.
“It’s really designed to target players with concentrated directional risk, which we’ll probably see more of over the course of the next year as positions in the clearing book become more mature. Some clients will be long assets, and will be very happy to pledge them. That will reduce the intraday funding burden on the FCMs, and they will presumably reflect that through pricing. Although we didn’t instigate this with the aim of reducing intraday funding costs, it is clearly part of the solution,” Bruce Kellaway, global head of RepoClear, EquityClear and collateral at LCH, told Risk.net in January.
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