The advent of the Uncleared Margin Rules (UMR) has not only put pressure on firms to make their systems compliant with the regulations, but has also put a drag on real returns as a result of the increased need to post margin on products which were previously not collateralized.
Pension funds, asset managers and traditional long-only funds are the firms more severely impacted because with directional books and growing notionals’, the margin will continue to increase due to lack of any considerable offsets between positions.
This means trading derivatives in a world of regulations is not only about looking at returns but also about reducing the cost of trading.
Traditionally, traders and portfolio managers have only been concerned about the slippage or bid-offer as the dominant source of costs but with regulations imposing stricter clearing and margin rules, the cost of funding the collateral for margin has to be taken into account as well.
This funding collateral has a two-fold impact on returns, typically known as collateral drag:
- Cost of funding this collateral at their funding rate.
- Opportunity cost of being constrained to trade due to lower unencumbered cash levels.
The good news is that there are solutions to optimize margin requirement and hence reduce the associated costs. As with using bid-offers to determine the slippage before the trade, there are solutions which can help understand the cheapest clearing brokers or bilateral dealers when taking the associated margin costs into account.
To illustrate the importance of Pre-Trade Optimization, we simulated a RV Hedge Fund clients’ historical cleared book from the start of year – with an empty book – to the end of year.
During this period, the client would regularly trade cleared swap trades in EUR, USD and GBP. The client had 3 clearing brokers, however instead of allocating the trades to the cheapest broker, the client used a simple allocation rule of allocating all EUR trades to one broker, all USD trades to another and all GBP trades to the third broker. Clearly, one gets offset between the trades of same currency but loses out on offsets among currencies, which being a RV fund is one of the most common trading strategies.
Using our proprietary, industry leading, Pre-Trade Optimization we see that the current currency allocation under performs considerably as the trading activity builds over the course of the year.
Utilizing the Pre-Trade Optimization helps in saving around 40% margin on average over the course of year.
In the above simulation, we used Pre-Trade Optimization. As you can see, the savings are lower to start with but grow significantly over the course of year and the average margin requirement over the course of the year is roughly 150mm lower, which means 150mm lower collateral to be funded.
This saving has a two-fold benefit:
- 150mm less collateral to be funded by the treasury, a direct reduction of the costs in the bottom-line.
- 150mm of collateral freed which can be used to put more trades or size-up on trades to generate higher returns, if within the risk limits.
To understand further how Pre-Trade optimization tools can help you and your firm reduce collateral drag and optimize margin, click here to download our latest case study, ‘Taking control of IM with Forecasting and Optimization’.