Derivatives market participants have renewed their focus on capital and margin optimization in response to the high cost of capital and the regulatory push toward central clearing, according to Coalition Greenwich.
According to its recent report The Portfolio Margining Imperative for Interest-Rate Derivatives, the largest opportunity for margin optimization remains largely untapped.
“Netting of futures and swaps risk in a single clearinghouse would also reduce the potential for market participants being stopped out due to margin increases from volatility spikes,” said Stephen Bruel, Senior Analyst at Coalition Greenwich Market Structure & Technology and author of the report.
“Not only would individual trading entities benefit, but the financial system would see an improvement in risk efficiency,” he said.
“Limited portfolio margining opportunities are available to market participants today, reducing portfolio margining efficiency and scale. As such, portfolio margining has room to grow,” Bruel added.
Margin requirements can be safely reduced when offsetting positions within a firm’s portfolio are held at the same clearinghouse. However, today’s competitive landscape has largely kept U.S. dollar denominated swaps and futures tied to U.S. Treasury and SOFR rates separate.
Higher capital costs have compelled derivatives market participants to be more strategic about how they optimize their margin obligations, driving changes to where they trade and how and where they clear the instruments, Bruel said.
Banks interviewed recently by Coalition Greenwich say “capital efficiency through netting and margin optimization” has become an important factor in how they measure their relationships with central clearinghouses (CCPs).
Bruel said that USD swaps and USD interest-rate futures have been cleared separately for as long as clearing for those products has existed.
He noted that FMX, which already provides a platform for cash UST and FX execution, recently launched its futures exchange for SOFR futures, with UST to follow in Q1 2025.
FMX will not directly clear the trades; rather, they have entered into a partnership with the London Stock Exchange Group’s LCH, who will clear the trades through LCH’s Listed Rates service.
A partnership between FMX and LCH is aimed directly at the costs associated with these fragmented margin pools and has reignited the cross-margining discussion amongst market participants.
Bruel said that FMX’s 10 current partners include the largest banks and market makers, and 7 of the 8 largest futures commission merchants (FCMs).
“Given CME’s current market share as sole incumbent in U.S. rate futures, differentiation in margin efficiency becomes paramount for FMX or anyone hoping to compete,” he said.
According to the report, interest-rate derivatives posted margin has increased by 108% since 2017, reaching $331.8 billion as of the end of 2023.
The CME is the primary clearer of U.S. rate futures and, thus, holds a majority of that margin, with no U.S. rate futures margin held at LCH prior to the FMX launch (the FMX partnership is LCH’s first foray into U.S. rate futures), according to the report.
“Portfolio margining at scale between offsetting U.S. rate futures and USD (and non-USD) swaps would free up significant capital for other uses,” Bruel commented.
He added that reducing margin obligations post-trade is beneficial; knowing the optimal path to maximize potential offsets before you trade will help achieve those benefits.
“Large entities could have a substantial number of positions spread across multiple clearing members.” he said.
“Regardless of the instrument type, derivatives traders therefore seek to know the margin implications of a new trade before they decide on the trade path, so they can act accordingly,” he said.
“Embedding tools such as LCH’s Rates Margin Calculator or CME’s Margin Calculator can help evaluate potential margin benefits through what-if analyses for incremental trades, including across swaps and futures. Reviewed pre-trade, this helps control margin costs. Approaching the margin issue from a pre-trade, trade, and post-trade perspective will provide the greatest benefits,” he added.
Bruel said that competition and choice are critical in financial services.
“But the launch of FMX and its partnership with LCH should lead market participants to refocus their efforts on margin efficiency in hopes of freeing ever-valuable capital to where it is most needed,” he said.
