By Joe Midmore, Chief Commercial Officer, OpenGamma
With September 15 marking the 15-year anniversary of the collapse of Lehman Brothers, the ripple effects that it had through global financial markets are still being felt in many different ways. Lehman Brothers’ collapse was, of course, in part triggered by its exposure to highly complex derivatives. The widespread use of over the counter (OTC) derivatives like credit default swaps (CDS) and the opacity of these markets contributed to the crisis.
In the aftermath of the collapse and the broader financial crisis, regulators around the world have sought to address the risks associated with derivatives trading. One of the key responses over the past one and a half decades has been the implementation of clearing and margining requirements for OTC derivatives.
Take the enforcement of the global uncleared margin rules (UMR) as a prime case in point. UMR has been phased over the past six years to enhance transparency, risk management, and stability in the financial system by addressing some of the issues exposed by the financial crisis, including the use of derivatives.
The purpose of the regulation was to introduce standardised margin for uncleared (OTC) trades which ends up making it more expensive to trade bilaterally (driven by higher margin requirements) which, ultimately, makes clearing more attractive and, in some instances, results in participants having to de-lever. UMR does this by requiring companies to post upfront collateral as security when doing trades, tying up trillions of dollars of assets that could otherwise generate returns.
It encourages a shift away from the bilateral OTC world, into clearing through CCPs, which aim to reduce counterparty risk by providing a central entity that guarantees trades. This move has broadly speaking helped to reduce risk among the investment banking community but it has also meant that hundreds of asset managers and pension funds (with portfolios above €8bn in notional) that have previously never had to post initial margin, have been forced to do so. This has presented a major operational and liquidity challenge for any company doing large volumes of non-cleared OTC trades.
Since the UMR rules started to be phased back in 2016, thousands of companies have been made to carry out huge amounts of work at the same time. In addition to the operational impact of this task, these changes have significantly increased the cost of trading. The intended effect of these changes is that companies will be strongly incentivised to stop two parties trading a contract between each other (bilaterally uncleared), and move towards central clearing for any trade that can be cleared. While clearing also involves posting margin, this is typically close to half the level of bilateral trading (5bp).
There is also a huge question mark over whether banks that provide clearing services have capacity on their balance sheets to cope with a barrage of firms now looking to clear. Although many companies have clearing agreements in place, clearing brokers are unable to offer long-term clearing certainty and therefore retain the right to pull access to their services with as little as one- or two-months’ notice.
Global financial markets are, of course, structurally very different to how they were 15 years ago. With regulatory changes, such as UMR, that have occurred over that time to financial market stability, firms have had to adapt. They must rely on doing things the way that they did in what is now essentially a totally different era. When all is said and done, the need for non-bank institutions like pension funds and asset managers to work out how to efficiently post and optimise their margin obligations is significant, especially when one contemplates the vast changes to market structure since the collapse of Lehman.
