Cross margining of derivatives: can it work?

There have been a couple articles on cross margining of derivatives recently, mostly focused on netting exposures within CCPs. This has been a hard nut to crack.

The three articles that caught our attention were:

• “Margin offset competition concerns clearing members”, by Gildas Le Treut of ABN Amro, August 1, 2014, The Trade News
• “Is cross margining all it’s hyped up to be?” by Daniela Schroeder, July 28, 2014, DerivSouce
• “The Future of Clearing” by Hans-Ole Jochumsen of Nasdaq OMX, July 28, 2014, Tabb Forum

Lets look at “Margin offset competition concerns clearing members” first. The article highlights the risk that clearing members take when CCPs cross-margin trades. From the article:

“…central counterparties (CCPs) are offering collateral efficiencies through margin offsets between OTC and exchange-traded derivatives, a move championed by the buy-side, due to the cost savings…”

“… with margin offsets being used in a competitive fashion, there is risk of under-collateralisation in a crisis…”

 “…I think the general concern is that there is a race to the bottom between CCPs,” said one person familiar with the matter…”

A couple years back, the fear was that CCPs would go easy on eligible collateral requirements and this would be used to compete for market share. While there still is pressure to widen out the eligible collateral net, it hasn’t proven to be the competitive differentiator that some feared. Instead, the push to cross-margin products within a single netting pool seems to be driving CCP business models. For example, CME allows for cross netting for Deliverable Swaps Futures and Cleared IRS. LCH looks like they want to do the same.

The article cited Eurex’s efforts to cross-margin, but there was criticism. Quoting Le Treut, the author of the article:

“…If you are only dealing with equities you don’t want to be blown up because a dealer has made issues on IRS,” he continued…

“…Cross-contamination should be avoided, and once you do an offset between two products, there is a link in the default funds. So the GCM would rather have a very straight CCP in terms of risk management and safe CCP, rather than it doing cross-asset correlation…”

A Eurex spokesman disagreed:

“…”The last thing we as a CCP want, is to run the race to the bottom on the margining side,” said Matthias Graulich, chief client officer of Eurex Clearing…”

The DerivSource article, “Is cross margining all it’s hyped up to be?”, interviewed Daniela Schroeder of Commerzbank. She noted that to take advantage of cross margining, clients might have to change their trading strategy.

“…a firm should have the same clearing broker for both cleared and exchange-traded derivatives (ETD) workflow, which is not necessarily common practice today. Traditionally, the ETD and OTC derivatives businesses have been siloed, often housed with different clearing brokers and each with its own liquidity pool. Cross margining is ideally suited to firms who use a single clearing broker manages both ETD and OTC cleared accounts and can establish a joint Means Fixed Income (MFI) liquidity pool to offset trades or positions for both streams to reduce the total number of margin calls…”

and

“…If a firm is eager to employ a margin reduction strategy we suggest they consider two changes if applicable: change the current investment strategy from just ETD or just OTC to a combined strategy, and review combined strategy to ensure there are offsetting positions.  Essentially the ETD and OTC positions need to have the same risk profile and are offsetting, otherwise no cross product margining can be used…”

Schroeder’ point about offsetting positions is important. Without naturally offsetting positions, there may be few places to hide from the demand for substantial increases in margin. There has been some research that says that the long only buy-side is not going to see nearly the advantages that the sell-side has on margin netting simply because of fewer offsets.But for, say, a hedge fund that has offsetting positions in instruments with correlated risks, the advantages of keeping positions in a single netting pool may be huge. Margin offsets are also dependent on account structure — if there are different accounts or clearing venues, then cross-margining won’t work. But placing all your eggs on one venue creates its own (concentration) risk.

From the “The Future of Clearing” article:

“…Cross-margining has emerged as a valuable tool to tackle [the capital efficiencies] challenge. Currently, this is done to varying degrees across the industry, whether it’s cross margining across OTC and exchange-traded products, or net margining across multiple asset classes. It is where many CCPs have been able to differentiate their offerings based on their risk appetites…”

The article went on to emphasize that collateral management, and in particular optimizing the use of collateral as margin, would conserve resources….and that technology would be critical in achieving those objectives.

We remember New York Portfolio Clearing (NYPC), a joint venture of DTCC and NYSE Euronext. They wanted to create netting pools which included IRS cleared in LCH.Clearnet. From a March 14, 2012 press release:

“…combining NYSE Liffe U.S.-traded interest rate futures contracts already cleared by NYPC, fixed income cash and repo trades cleared by the DTCC’s Fixed Income Clearing Corporation (FICC) and interest rate swaps cleared by LCH.Clearnet’s SwapClear service into a single portfolio for purposes of margin netting and offsetting…”

The project seems to have faded away.

Getting the cross-margining right is difficult. In a stress situation, anticipated correlations go out the window and what was balanced offsetting margin one day can turn into a deficit the next. When collateral is held in an omnibus account, “other customer risk” makes the risk assessment even more complicated. Unraveling who gets what in a default situation in an omnibus account will be a nightmare. Multiple CCPs aligned by product are cleaner from a default perspective. But the efficiencies necessary for reducing margin are much harder to come by then. One big CCP covering all products is ideal for cross margining, but that opens a whole other can of worms. What is the right recipe?