In the regulatory push toward central clearing, one of the biggest changes that asset managers and hedge funds will face are margin calls on swaps and other cleared derivatives.
Though clearing of swaps contracts is not yet mandated, most dealers and derivatives vendors expect it to happen by the end of 2012. When dealer-to-customer clearing takes off, buy side firms that use OTC derivatives like interest rate swaps could be facing high volumes of margin calls as these new instruments are cleared.
In today’s world of bilateral derivatives where the dealer takes on the risk and clears the trade, on average, clients receive one margin call per week for each credit support document (CSD). (The CSD is a document under ISDA that defines what the margin requirements are to be.) But once the clearing of derivatives becomes mandatory, cleared calls for some of the CCPs could be up to six calls per day for a single CSD. “They’re going to process orders of magnitude of more margin calls," according to Craig Welch, CEO of AcadiaSoft, developer of MarginSphere, an online community for margin confirmation.
Welch started on the bilateral side building a collateral management system and noticing all the emails flying back and forth between dealers and the buy side clients. He has worked with several buy side and sell side firms to put together an online community, so that participants could communicate the margin calls more efficiently.
On Feb. 7, AcadiaSoft announced that three buy side firms, Bluebay Asset Management and Cheyne Capital Management and Goldman Sachs Asset Management would be live on MaringSphere. In late 2011, the firm said that Deutsche Bank, Goldman Sachs, HSBC and J.P. Morgan were among the first sell-side firms to go live on the solution.
Some of the large sell side firms have their own collateral management systems have embedded have embedded Acadia into their own system, so there is no more email, while smaller hedge funds have the option of accessing the messages via a browser.
Very soon, in addition to the banks issuing bilateral margin calls to the buy side, the CCPs are going to start issuing all the cleared calls as well, notes Welch. In response to the margin calls, buy side firms will need to post collateral.
This is something they haven't experienced before. Going back to the credit crisis in 2008, a lot of derivatives were not collateralized. In the bilateral derivatives world, the dealers were taking on the risk and didn’t necessarily require their clients to post initial margin. They had to post variation margin if the position moved against them. But in the new cleared model, trades that are accepted for clearing through the CCPs, will be required to post margin. Some these messages will come through the pipes as well.
But, as CCPs issue their margin calls on the cleared swaps, this has the potential to get very complicated.
“When the market has matured, when you’ve got some of your transactions in bilateral and some in ICE, some in CME and some in LCH.Clearnet, the margin calls could go off the chart,” predicts Welch.
Imagine all these margin calls flying around and banks asking their clients to post, say $1 million in acceptable collateral. And what if the investment firm disputes the amount of collateral that’s requested? “If you’re a big bank you could have thousands of margin calls a day and then the average margin call involves six emails going back and forth,” illustrates Welch. “Lets’ say you issue 2,000 margin calls a day, and those 2,000 generate six emails back and forth on average, you’ve got to have a lot of bodies,” he continues. “Now, conceivably those margin calls are going to go up by orders of magnitude.”
What MarginSphere does is consolidate all the calls coming in through a single pipe, and go through their collateral management systems, and consolidate both the bilateral and cleared trades into common process and workflow.
To be effective, it’s important for systems like MarginSphere to gain critical mass on the buy and sell sides. Right now the firm is busy signing up dealers and already has 80 percent of the top 35 sell side firms. On the buy side, some of the banks will invite their clients to access the system, while hedge fund administrators are also providing access to 50-to-100 hedge finds at a clip. Third, AcadiaSoft has a partnership with MarkitServ, the leading swaps affirmation and confirmation service, so buy side firms can access MarginSphere through the MarkitServ’s screens directly.
Although swaps clearing hasn't taken off yet and the sky is not falling, if these predictions come to pass, then tracking margin calls sent from multiple CCPs and dealers could be a mess. AcadiaSoft is but one technology firm shining the light on this process. Buy side firms should look into automation as the new cleared model gets underway.