By Jo Burnham, Risk and Margin SME, OpenGamma
If the failed rebellion by Russia’s Wagner mercenary group taught us anything, it is that the war – which just surpassed 500 days in length – is far from over yet. This will have several lingering market implications, none of which are particularly pleasant. But financial institutions can take concrete steps to insulate themselves against a few of these – one such concern being surging margin costs.
The Russian invasion of Ukraine has had a significant impact on the price of derivative contracts, with liquefied natural gas and wheat futures witnessing pronounced price volatility due to their close dependence on Russian energy and crops. As a direct result of this, margin costs related to these contracts have spiked dramatically over the last year or so. Margin on Dutch gas futures traded on Intercontinental Exchange (ICE), for instance, rose 38% on 9 March last year, following a 36% rise on 4 March – a doubling of margin in less than a week.
While rises in margin costs are unlikely to be as pronounced over the coming months, we can certainly expect cost volatility to remain elevated for the foreseeable. With this in mind, market participants are understandably exploring their options with regards to the method in which they trade certain derivates, shifting between exchange-traded derivative (ETD) markets and over-the-counter (OTC) exchanges, which have differing margin requirements. This certainly seems a prudent approach, with the cost of leaving capital tied up needlessly in collateral requirements highly unattractive in the current macroeconomic climate. Nevertheless, there are several crucial differences between these options investors should closely evaluate.
Complex collateral
Many market participants moved natural gas positions from ETD to OTC over recent months due to margin cost concerns. While margin rates were already high following the Covid-19 pandemic, they nearly doubled when Russia invaded Ukraine. Often the margin rate is defined as a percentage of value, so as soon as prices began to rise, so did margin requirements. Additionally, the percentage applied rose in reflection of heightened volatility, further adding to the pressure on liquidity.
Meanwhile, the change in OTC initial margin requirements was much less marked, mainly because the International Swaps and Derivatives Association typically only reviews its parameterisation of the SIMM methodology on a yearly basis. Put simply, when volatility was at its highest, it was advantageous from an initial margin perspective to move risk to OTC – especially if taking advantage of the €50m regulatory threshold. But this may no longer be the case. ETD margins have reduced significantly over recent months, while OTC margins increased at the end of 2022 following a SIMM upgrade.
But there are other elements that must not be overlooked, not least variation margin. For ETD contracts, profits and losses are paid on a daily basis in the form of variation margin. As prices rose as the Ukraine war broke out, the need for daily cash flows caused major liquidity issues for firms holding short positions. Some were forced to close these positions and look to reopen similar positions OTC to keep hedges active.
On OTC markets, profits and losses are paid at the end of the contract, resulting in better alignment between cash flows on derivative and physical positions. This was a real advantage, as many of the firms impacted by liquidity issues actually had overall profit-making portfolios. Now, however, firms that moved to OTC are wondering whether they might be better returning to ETD trading. As prices fell from their early highs, they would have been receiving daily profits on short positions, but if they had traded the same risk OTC, profits would not have been paid out until the end of the contract.
Given these complexities in accurately determining the best approach with regards to margin, market participants must assess and enhance their margin capabilities. From a cost and risk perspective, this means firms need to consider the optimal way to trade the required risk. To achieve this, it is critical institutions deploy technology that can quickly and reliably assess pre-trade options, to identify the optimal venue through which to trade, as well as post-trade, to rebalance the position and keep margin costs to a minimum. With the potential for explosive derivative price movements set to persist for the remainder of the year and beyond, investors must now prioritise margin cost mitigation – suffering collateral damage is simply not an option.
