Margin matters – A smarter approach to margin risk

Michael Hollingsworth, head of financial risk analytics in the Data and Access Solutions division at Cboe Global Markets, reveals how trading firms are calculating margin in real time to manage pre- and post-trade risk and end-of-day clearing-house requirements

Why is margin considered one of the most important measures of risk and what makes it different to portfolio risk?

Michael Hollingsworth: When it sits on a risk manager’s desk, portfolio risk is more of a theoretical concept. Using risk models and stress-testing gives an idea of how much money a trading firm could lose, but they aren’t definitive. A trading desk will need to evaluate whether the risk is justified based on the return they can make. 

Conversely, margin risk is structured risk and is better defined. Margin methodology is a more tangible risk methodology and shows, under a particular risk, exactly how much will be needed to cover a potential loss. The outcome is that money changes hands, which is why, in our view, it is the most important measure of risk.

Asset owners and managers come to Cboe because of our ability to provide that risk margin calculation in real time. This information allows them to trade more tightly to their capital limits and gain more leverage. They also don’t have to build in as big a cushion for potential surprises in the margin and where they would require the liquidity to meet those requirements.

How are market participants able to manage pre- and post-trade risk more efficiently with Cboe Hanweck? 

Michael Hollingsworth: Whether we are talking about pre-trade margin or pre-trade risk, market participants want to know if they can calculate margin in real time. You can, but you need real-time analytics feeding into it. Cboe Hanweck’s core value proposition is the machinery to conduct real-time risk analytics, which is hard to do well. But that’s the foundation for a margin calculation. 

From market data, we compute real-time volatility surfaces, then we calculate up-to-date scenarios and build the margin logic on top. If you don’t have good risk analytics to feed into the model on a pre-trade basis, you will get noisy baseline margin calculations. And, critically, you will not have learned what the margin impact is – whether that particular trade really will add margin. 

This hits harder on the pre-trade side than post trade. Having the ability to calculate margins intraday is important so investors are not caught off guard. They don’t want to be surprised by a call from their broker at the end of the day asking them for large sums of money to cover a recently increased margin.

How do the differences between clearing houses’ methodologies affect market participants? 

Michael Hollingsworth: There are 50 or more venues that use the Standard Portfolio Analysis of Risk (SPAN^®) system, with various flavours. This area is constantly evolving and there are new margin methodologies on the way, such as the Theoretical Intermarket Margin System, or TIMS, and CME Group’s SPAN 2. There are also integrated exchange and clearing houses coming out with new methodologies. 

Twenty years ago, a hedge fund would have had one or two prime brokers. Today, trading firms have a dozen or so where they need to get cleared. They want the flexibility to clear through as many venues as they can, yet do so efficiently. Offering as many different margin methodologies as possible under one roof, as well as a consistent interface or application programming interface in which to see the whole book, means a firm can modify the parameters and send in different portfolios. Operationally, this allows them to efficiently manage multiple venues. 

What are the challenges of margin optimisation and what efficiencies are firms seeking?

Michael Hollingsworth: When a hedge fund is working across different venues with different methodologies, the efficiency they seek is making sure that, when they conduct a trade, they know which venue to clear it through to get the best margin offset. 

On the sell side, optimisation is a different exercise. Often, the sell-side firm or the prime broker wants to ensure they are allocating the cost of capital correctly to support their customers. Positions are offset and net with the different methodologies. Among larger sets of customers, where there is a lot of offsetting happening, those participants want to understand which customers are reducing their total margin and which are adding to it. If they know roughly what a potential customer’s portfolio looks like, they will have a better understanding of how bringing them on board will impact their margin. 

So, for the sell side it’s important to know which customers are driving their requirements with their clearing relationships. Having the tools to calculate cost margin attribution avoids the potential for mispricing a customer.

In certain methodologies, the margin requirement, or collateral, gets folded into the risk portion of the margin calculation. Collateral optimisation allows to offset the credit and free up cash by calculating the net asset value for the exposure that stems from the collateral.

How does the interconnectedness and complexity of capital markets affect margin requirements while market participants look to assess trades and pursue investment strategies?

Michael Hollingsworth: As an example, let’s take a global hedge fund based in the US that will lose a lot of money if the Asian markets start to melt down overnight. Margin requirements go up in response, leading to a margin impact on top of the profit-and-loss impact. When the European and US markets open, they will probably follow the move down and have the same impact. At any given time during the trading day, a firm could get a margin call and they want to be able to stay on top of that. 

It is important that large global firms have a follow-the-sun capability. They want to be able to calculate across multiple venues throughout the day in a real-time analytics framework. They also need to compute theoretical prices in options analytics before the market opens to calculate margin. This is where Cboe Hanweck comes in. Its real-time risk analytics are unmatched in the industry, and delivering this essential service to clients worldwide is what drives it every day.

 

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