Where compression seeks to offset economically similar trades to reduce notional, optimisation seeks to free up committed margin and capital by placing a series of market risk-neutral trades. The aim is to improve profitability by reducing the use of resources, allowing them to be redeployed towards trading activity. Optimisation largely operates by freeing up:
For larger institutions that operate in multiple distinct derivatives markets, optimisation can reveal trades that will lead to a degree of consolidation, releasing IM and/or capital without impacting their net position. This is very pertinent to OTC derivatives dealers who tend to hold offsetting positions across multiple clearinghouses, exchanges and bilaterally with counterparties. The significant fragmentation of these markets ensures that a multilateral approach works best, ensuring that there are sufficient participants in each liquidity pool to make optimising trades.
Optimisation services are extremely useful in freeing up scarce resources, especially given the current trends on market volatility and the direction of regulatory change.
The gradual adoption of Uncleared Margin Rules (UMR) place more burdensome regulations on dealers in uncleared OTC derivatives, requiring both counterparties to post IM with a third-party custodian, in line with the SIMM. This regulatory burden will likely increase the costs associated with making a market in uncleared OTC derivatives.
For cleared derivatives, periods of market stress can lead to CCPs demanding higher quality collateral or applying larger haircuts based on internal modelling that responds to market volatility. This can increase funding costs and lead to more capital being tied up in maintaining positions. For instance, the pandemic-induced turmoil in Q1 2020 led to IM held by seven major clearinghouses to rise to $833.9 billion from $563.6 billion[1]. Such procyclicality in IM requirements has the potential to hamstring dealers from providing liquidity to derivatives markets along with impacting their ability to continue trading and generating revenue. This is especially problematic given that higher levels of volatility drive trading volume, making these brief periods very lucrative for dealers.
[1] Futures Industry Association (Oct 2020), “Revisiting Procyclicality: The Impact of the COVID Crisis on CCP Margin Requirements”
N.B. Sample of CCPs included CME Clearing, Eurex Clearing, ICE Clear Credit, ICE Clear US, CE Clear Europe, Japan Securities Clearing Corporation, LCH Limited, LCH SA and OCC
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