Shadows of Crises Past: Margin Calls Strain Financial Markets

March and April volatility exposed operational inefficiencies for trading counterparties that have yet to automate their collateral management processes, says DTCC’s Purtini Joshi.

As the Covid-19 crisis gripped the world, fear and uncertainty left many traders searching for liquidity, leading to asset fire sales and the unravelling of complex trades. Market volatility spikes and margin calls reached unprecedented highs throughout March and April of this year as broker/dealers liquidated exposed – and potentially exposed – derivative positions.

While CCP margin models were deemed effective in protecting the financial system as a whole, this was not an easy operational process for many market participants. Indeed, some firms needed a few days to determine which derivatives contracts were actually exposed versus those which were merely awaiting margin settlement, as staff still apply predominantly manual methods to handle the settlement and collateral management process.

As one asset manager in Asia explained, Covid-19 related volatility sometimes triggered multiple margin calls per day from a single counterparty. In the end, the firm occasionally had excess collateral sitting with one counterparty while another was calling for additional margin.

Unfortunately, this is not a new scenario, and we’ve been down this road before at the height of the 2008 financial crisis, when volumes spiked and margin and collateral operations felt the pressure.  The time is now to learn from the lessons of 2008 and 2020, and address this critical operational area.

Automation lags in middle offices

Despite technological advances that have automated front-office processes across many asset classes, much of the middle-office activity around margin calls and collateral movement remains manual and separate from the automation leveraged by other departments at a firm. And even at the most sophisticated brokers, the collateral management process is separate from the settlement process.

Although automation exists, many margin processes today still rely on faxes, emails and other manual methods, resulting in slow, bifurcated processing, a lack of transparency and elevated error rates. In normal times, these manual processes have been manageable and have been largely overlooked, but in times of crisis and extreme volumes and volatility, a lack of collateral management automation can impede a firm’s day-to-day activities and capital efficiency.

While regulators implemented several rules to improve transparency and safety in derivatives markets following the 2008 crisis, including mandates which specifically impact margin call processes, most tend to be agnostic about how financial service firms manage their collateral operations. As long as initial margin is allocated for all unsettled derivatives and qualifying institutions exchange variable margin as prices move, the regulatory requirements are met and firms can choose whatever means they deem adequate to achieve this.

Smaller firms are the tail that wags the dog

As a result, we currently see a market where most of the larger firms have automated their collateral management systems, but the benefits — in the form of lower risk and higher efficiency — aren’t being fully realised. Rather, when volatility rises and margin calls spike, settlement tracking becomes a labour-intensive project for all parties regardless of size, and a large number of counterparties aren’t prepared from an operational perspective.

In March and April, we saw manual collateral management and margin systems at multiple firms being quickly overwhelmed. The separation of these systems lead to significant reconciliation struggles, leaving transacting parties unsure of their collateralisation standing at the end of each day and the beginning of the next day.

If the challenges of supporting the volumes and volatility during the 2008 global financial crisis did not convince firms to automate collateral management then, after the most recent spike in volatility, the time to act is now. Two scenarios come to mind.

In the first, the final stages of upcoming uncleared initial margin regulations — delayed to September 2021 and 2022 — are anticipated to lead to an increase in margin call volume even in normal market conditions, leading firms to prepare for higher volumes.

In the other scenario, broker-dealers could start assigning a cost to the level of risk that manual collateral management exposes them to, encouraging smaller firms to adopt in-house collateral management systems, sign on to a third-party collateral management utility, or pay higher transaction fees to offset the increased risk associated with their positions.

However the situation plays out, market volatility during the pandemic was just the latest of a string of crises that have impacted volumes and volatility and highlighted the risks associated with manual collateral management processes. These issues are sure to resurface the next time we experience a market event.

Firms that do not take advantage of periods of relative calm to automate their collateral management processes will find themselves at some point facing more expensive contracts or, even worse, being forced to liquidate positions in periods of market stress.

Purtini Joshi is Collateral Management Executive at DTCC.

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