The CME's Paulhac on cross margining of futures and cleared swaps: big savings but complicated

An interview on with Laurent Paulhac, Senior Managing Director, Financial and OTC Products & Services at the CME on collateral cross margining caught our eye. It helps clarify how cross margining will work across the CME’s cleared swap and futures.

Paulhac said, “…Portfolio margining is the ability to take a diverse portfolio of instruments that are highly correlated, and look at the overall risk on a combined basis, and margin the portfolio as a group…”

The key words here are highly correlated. Margining orange juice futures along with, say, crude, achieves no efficiencies. Whereas “… for highly correlated commodities products, such as WTI, Brent, and DME Oman Crude contracts, as well as natural gas…” it works just fine.

But the there are differences between futures and interest swaps and how initial margin in calculated. “… Interest rate swaps are margined on an HVaR (historical value-at-risk) basis, with a 5-day margin period of risk (meaning the market holds enough margin to cover a 5 day liquidation period under a default scenario). Eurodollars, and other futures products, are margined on a SPAN basis, which assumes a one-day liquidation period…” We wrote about this in our recent papers on the futurization of swaps, “The Futurization of the Swaps Market: Players, Products and Collateral” (March 2013) and “A Guide to Margining for Cleared OTC Swaps vs. Margining for Futures” (April 2013).

This has become a controversial topic. Deliverable swap futures on the CME are margined like other futures with a one-day liquidation period assumption. But when that swap is delivered, it morphs and is now margined using 5-day HVaR. Initial margins are higher the longer the time horizon is – so the 5-day cleared swap will have a higher margin than the swap future, despite being otherwise equivalent. Lawsuits are already flying with potential SEFs being particularly annoyed.

But the process isn’t as simple as combining the positions and seeing where the offsets are.

“So, suppose a client wants to take advantage of portfolio margining between, say, a swap and a Eurodollar. What the client will need to do is take the futures position out of the 4(d) account, which is a “commingled” futures account, and place it into a separate, “sequestered” OTC account. When the funds are moved, we will recompute the margin requirement using HVaR. We will then apply the algorithm to understand how these risks offset each other, to determine the total margin required…”

In order for the swap future to take advantage of the cross margining, it will have to be put into a “sequestered” OTC account. At that point initial margin will be calculated using the bumped up 5-day HVaR – but the trades will get the full benefit of the margin offsets at that point. This does not involve a dump off all futures contracts into the “sequestered” OTC account – it is a complicated optimization process, picking which and how many to port over in order to minimize initial and maintenance margin. Paulhac said, “…one of the firms that has taken advantage of portfolio margining has already saved about a billion dollars in margin…” Those swap futures which don’t move retain the lower initial margin using the SPAN methodology — so you don’t want to transfer too much over.

Another interesting aspect of the “sequestered” OTC account is that it is subject to LSOC versus the traditional omnibus account structure for futures contracts and the “fellow customer risk” that entails. Paulhac said “…Once the futures are removed from a commingled account and put into the sequestered OTC account, it follows LSOC (“legally separated; operationally commingled”) rules, which are still commingled, but with additional operational and reporting rules overlaid to them, effectively adding more client protection…”

This functionality has been available to clearing members since March 2012. It is being rolled out for customer accounts, but so far it has been slow going given the complicated technology involved. The CME hopes that sometime in May more client accounts will be up and running. The CME has looked at margining on a FCM level and clearing members then slice and dice by client. Depending on the mix of client positions, sometimes the margin at the clearinghouse does not equal the sum of the parts for the FCM, creating exposure to the FCM.

A link to the interview is here.

A link to the Finadium papers synopses are here and here.

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