May 16, 2023 | Stamford, CT — Regulations passed in the wake of the Global Financial Crisis are widely credited with ameliorating many of the most pernicious systemic issues previously inherent in the derivatives market. However, according to market participants, those rules could hurt liquidity and drive up costs.
Specifically, regulations such as Standard Agreement of Counterparty Credit Risk (SA-CCR) and the Uncleared Margin Rules (UMR) are prompting firms to focus on their usage of capital and margin.
“Capital and margin affect what you decide to trade, how you trade, how you process those trades, and the economics of the trading desk,” says Stephen Bruel, Senior Analyst at Coalition Greenwich Market Structure & Technology and author of Derivatives Market Structure 2023: Optimization is not at the Margins. “As a result, the new rules on capital and margin are having an impact on the derivative trade lifecycle and influencing portfolio decision making.”
SA-CCR was initially proposed by the Basel Committee on Banking Supervision (BCBS) in December 2014 to create a more risk-sensitive method for calculating and holding capital against counterparty credit risk, an inherent feature to bilateral over-the-counter derivatives trading. Altering how credit risk is calculated resulted in counterparties having to hold more capital against OTC trades. In addition, dealers that are Global Systemically Important Banks (G-SIBs) have to hold higher capital buffers, which increase with the bank’s “systemic importance.” Overall, more capital held means higher costs, which may drive more trades into clearinghouses.
“Capital requirements present a liquidity risk as well,” says Stephen Bruel. “Market participants state that they are keeping an eye on how the liquidity implications of capital requirements could change trading dynamics.”
Firms are working to mitigate the impact of these changes by improving multiple processes in the trade lifecycle; this work includes a strong focus on collateral and capital optimization.
“The definition of collateral optimization is changing, and best practice going forward will require a pre-trade scenario analysis to determine the most efficient way to trade an instrument,” says Stephen Bruel.
Such improvements will help reduce operational risk and enable better front-office decision-making. This is vital because the implicit costs—perhaps in the form of a less liquid market—and the explicit costs in the form of increased margin and or capital will all play a role in portfolio manager decision-making.
Derivatives Market Structure 2023: Optimization is not at the Margins analyzes the impact of major regulations in the derivatives market since the Global Financial Crisis and examines steps market participants are taking to address any resulting decreases in liquidity and increases in costs. These steps include technology investments, the use of margin optimization tools and other enhancements.