Reducing the Cost of Capital Through Workflow Automation

By Scott Fitzpatrick, Chief Operating Officer, Acadia 

As global financial markets have adjusted to the added complexities of margining non-cleared OTC derivatives after the onset of Uncleared Margin Rules (UMR), there has been a noticeable need for greater industry standardization and common practices to simplify the calculation and management of Initial Margin (IM). This includes greater technical integration between risk management and collateral management infrastructures within an institution, greater transparency and reconciliation capabilities between institutions, and improved operational mechanisms around the posting and segregation of collateral. 

External service providers have long been used in the derivatives industry. With the implementation of UMR, it was paramount for service providers and vendors to enhance their capabilities. This was to support the increased automation of collateral management in order to streamline the process for the modern trading environment; while also helping firms meet current regulations and stay ahead of any changes to regulatory requirements. 

However, there are firms that still rely on inefficient and non-standard processes for collateral management (e.g. tactical calculation frameworks, manual reconciliations, reliance on email communication, limited automation to instruct settlement, etc.). This translates into a manually intensive end-to-end process (from calculation of exposure, or margin requirement, through to settlement) which reduces scale, leads to inaccuracies, processing delays, and limits any ability to focus on value-add activities for the organization. 

Whether a firm seeks automation by utilizing specialized third-parties or through investment into their own infrastructure, it is important to understand that a continued focus on automation is required to help mitigate the growing funding/liquidity/capital costs of posting collateral (notably regulatory IM). Improving automation will also create scale and minimize the operational risks associated with handling a greater number (and/ or size) of margin calls during periods of market volatility and duress. Additionally, once firms are more automated, they can start looking at their whole operation and pivot towards value-add activities. For example, firms which traditionally have been posting cash as collateral for operational simplicity can leverage systems that analyze the most optimal collateral to post across a wider range of eligible assets while also operationalizing that decision. 

Greater automation – the next game changer for derivatives 

As with nearly every industry, technological advances continue to drive automation and efficiency. This is true in financial services where even smaller firms that naturally have less efficiency and scale issues are focusing on improved automation. Taking collateral management as an example, firms that have yet to seek automation, now realize that moving away from manual email and spreadsheet processes to manage collateral operations eliminates potential risk and unlocks other benefits. 

These other benefits could be viewed as direct cost reductions or indirectly as an ability to help talented individuals focus on more value-added work. Freeing up a talented workforce from unnecessary manual work enables collateral operations to pivot to an exception management framework. This allows collateral operations to focus on risk management (primarily dispute and fail reduction) while also helping traders and portfolio managers optimize collateral and reduce funding and balance sheet costs. 

The paradigm shift 

Regulatory reform of the OTC derivatives market (e.g. UMR, the European Market Infrastructure Regulation (EMIR) and the Capital Requirements Directive (CRD)) has increased the complexity of common operational processes (notably collateral management). Portions of these regulations also led to a marked increase in the amount of margin calls and largely removed the optionality of collateralization. To cope with this complexity and increase in operational burden, the industry indirectly (or directly depending on perspective) adopted a greater degree of standardization and a greater willingness to improve transparency. 

As an example, the industry adopted a Standard Initial Margin Model (or SIMM) framework to calculate IM for trades that fall under the scope of UMR. Furthermore, the industry became much more open to sharing risk sensitivities with counterparties in order to aid in dispute resolution. These shifts in collateral management allowed for the development and implementation of an industrywide Common Risk Interchange Format (CRIF) along with the creation of industry tools to reconcile trades, calculate IM, and compare risk parameters/ sensitivities. It should be noted that standardization does not imply simplicity. For this reason, industry tools have widely been adopted by most industry participants. 

Though regulation certainly pushed the industry towards greater automation, the benefits are easily visible with relatively recent market events. The pandemic, geopolitical tensions, staffing challenges, and global inflation have directly impacted the financial system leading to greater operational and risk management pressures. Increased automation using industry utilities has allowed the industry to scale and possess the processing power needed to meet these demands. 

In the end, technology will inevitably evolve and adapt to the changing needs of the marketplace. Firms must continue to embrace the types of automated workflows that enable the seamless management of collateral, margin, risk, payments, and reporting. Automation mitigates risk, facilitates speed, and improves accuracy. These trends will not stop as they continue to unlock value and help firms improve resource allocation. 

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