It was a pleasure to be asked to moderate a panel session on derivatives at the latest Fixed Income Leaders Summit in early October. This session highlighted some serious challenges to the derivatives market and bold potential solutions.
Over the last three years, the derivatives industry has been hit by a wave of shocks from the pandemic to the Ukraine invasion, and economic turbulence after the UK mini-budget. These have all significantly impacted financial market stability.
Since the summit, the situation in the UK became even more serious as the Bank of England intervened to ease pressure on pension funds that have faced margin calls from counterparty banks and pressure to sell assets to top up collateral. But the Bank also made clear this support was short-term, meaning funds are having to be proactive in looking for other ways to shore up their liquidity positions.
Since the 2008 financial crisis, nearly all derivative positions, whether cleared or uncleared, are now margined, which means they borrow money from brokers to buy investments. This has transformed credit risk into liquidity risk, at least in part. As volatility increases, so does the size and frequency of margin calls, which occur when the value in a brokerage account falls below a certain level. Combined with the drying up of security and repurchase agreement (repo) markets, the challenge of meeting these margin calls in cash or securities is increasing.
In our panel, and in several other sessions, this problem was discussed with reference to the potential for all-to-all markets, cleared repo and evolution in real-time payments, settlements and pledging processes.
Tackling pressure on margin calls
At the summit, one question to our panel was, ‘How is the liquidity, clearing and settlement landscape changing and what does it mean for the future of the derivatives market?’.
Max Verheijen, financial markets director of Cardano, an investment manager servicing UK and Dutch pension funds, kicked off the debate by describing the impact of recent market volatility on liability-driven investment (LDI) funds. This instability has led to challenges such as increased margin calls and the decrease in value and liquidity of UK government bonds used as collateral against those positions.
Verheijen suggested the liquidity squeeze might be tackled by expanding the universe of eligible collateral. But he acknowledged that restrictions on the need for high-quality assets in the cleared space make this difficult.
Joe Midmore, chief commercial officer of collateral management services provider OpenGamma, highlighted the need for robust models to help firms forecast margin requirements and create appropriate liquidity management approaches.
The consensus was that derivatives markets are likely to continue their growth. We look forward to potential innovation in the industry that might help mitigate these current and future liquidity challenges. With participation from the audience, we also discussed the merits of cleared repo to increase the availability of cash and securities to meet margin requirements. We also discussed the potential for tokenisation to improve the transparency and cadence of the collateral settlement process.
How Delta Capita can help
At the event, I was glad to meet so many industry colleagues and have the chance to explain Delta Capita’s focus on managed service provision, strategic consulting, and resource augmentation.
I look forward to my full diary of follow-up meetings, which aim to discuss actions planned by individual firms. I also keenly anticipate Delta Capita’s involvement in industry working groups. We can help establish consensus and drive momentum toward solutions that will benefit the whole industry by promoting efficiency and market stability.
Delta Capita’s Payments and Market Infrastructure practice also helps industry groups address such challenges and opportunities and drive the design and adoption of solutions to meet those needs.
Contact us to find out more and speak to one of our experts.
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