The Future Impact of UMR
Banks are increasingly focused on optimising their use of liquidity and collateral, as capital efficiency moves to the top of the management priority list. While not directly linked to the roll-out of UMR, it is an important indirect result of the evolution of market structure. In particular, the velocity of collateral has become a focal point, and the ability to move assets in real time is an important consideration for both the front and back office. After all, execution speed is linked to the ability to move collateral; it takes longer to price a deal where the specific eligible collateral has a bearing on the execution price.
Faced with the possibility of having to hold greater liquidity buffers, some firms are using this opportunity to enhance their collateral optimisation and transformation capabilities by implementing more efficient systems and processes across a wide range of collateral services.
Participants may also consider market data from the moves associated with the COVID-19 pandemic, to test liquidity buffers and hold more collateral on their books. This could raise funding and capital costs further under UMR, which requires two-way margin to be posted. This is in contrast to clearing, where the execution dealer can net off positions with the same counterparty (the CCP) to reduce their IM liability.
Furthermore, clearing brokers can recognise only client-cleared IM for the Leverage Ratio. This is beneficial as the move to the Standardised Approach to Counterparty Credit Risk (SA-CCR) for Leverage Ratio and risk-based capital requirements will increase exposures for long and directional clients. However, unlike previous models, SA-CCR acknowledges the increased netting benefits that moving to clearing enables for neutral clients.
For clients, collateral management brings its own challenges. The inability to use securities as collateral for variation margin is a key reason why pension funds have not made a wholesale move to clearing (securities can be used as collateral for bilateral trades). As one pension fund manager explained, he needs to use the repo market to clear swaps, but if it is stressed and dries up, a lender of last resort (a central bank) is required.
Within the Eurozone, according to a recent European Commission paper, Dutch pension funds are the most involved in derivatives, with 89% of all pension fund interest rate swaps entered into by them. The analysis found that the actual liquidity needs of Eurozone pension funds in the event of a 1% shift in rates would be manageable (i.e. below 2%), as compared to the overall size of the European repo market (proxied by the outstanding amount of reverse repos).
Another solution to this is to use a service such as LCH RepoClear that can help source the cash for VM. Regardless, the firm needs enough collateral to fulfil its margin requirements and, since the dominant risk factor is interest rates, an obvious solution would be for CCPs to accept securities as collateral, as in the uncleared space. But this is not, unsurprisingly, as straightforward from a risk management perspective.
The full paper is available at https://www.lch.com/system/files/media_root/LCH_The%20Future%20Impact%20of%20UMR.pdf