U.S. Institutes Risk-Based Portfolio Margining

After years of investigation and discussion, a new risk-based portfolio margining regime took effect on April 2 in the U.S. The change marks a substantial amendment to the New York Stock Exchange (NYSE) and Chicago Board Options Exchange's (CBOE) margin rules, and is expected to produce significantly lower margin requirements for many investors, thus aiding cash flows and liquidity.

Traditionally, the rule of thumb has been that investors have had to put up a 50 percent initial margin for an equity trade, with an absolute minimum maintenance margin of 25 percent or higher, depending on house requirements, explains Jerry Quinn, VP and associate general counsel with the Securities Industry and Financial Markets Association (SIFMA). While there was a degree of recognition given to strategies that produced hedged positions, with a concomitant reduction in margin requirements, the approach that existed did not fully recognize that most of the risk is offset in complex/diversified portfolios. The result, therefore, has been overcollateralization.

But with more and more market participants, including traditional fund managers, incorporating equity futures and options into their portfolios, the old margin calculation system has come under growing scrutiny. As a result, in recent years the NYSE and CBOE — with the Securities and Exchange Commission's (SEC) blessing — have initiated pilot projects to move toward a more effective risk-based margining approach that does recognize offsets between related instruments.

The latest amendments mark the most comprehensive formulation yet, having extended the regime to include individual equities, listed and unlisted equity-based derivatives (such as options and swaps), securities futures and some related futures contracts. An SEC-approved theoretical pricing model is used to assess potential gains or losses across a customer's portfolio.

Still More to Be Done

In practice, market participants should be able to enjoy more capital freedom and efficiency. "We think that will be especially important for hedge funds and other large players across the option and equity markets," says Thomas Kloet, senior EVP and COO with Fimat USA, one of the first brokers to begin offering portfolio margining to qualified clients.

Brad Bailey, senior analyst with Boston-based consulting firm Aite Group, similarly thinks hedge funds will be big beneficiaries from the change. Another impact he expects to see is an increase in options volumes in the U.S. "We've already seen over the last five years an increasing institutionalization of options, and I think certain types of hedge funds will become very big players in various options strategies," he says.

Thus far, however, not many brokers have announced plans to offer portfolio margining facilities to their customers. Part of the reason for that could be that they need to figure out what slice of their customer base is the appropriate audience for such a service, which may take some time, suggests SIFMA's Quinn. "But I think over the course of the year you'll find more and more firms offering it," he adds.

Likewise, Aite's Bailey argues that, given the need for brokers to continually offer different services of interest to their clients, as market participants see the power that a risk-based margining regime will bring, "This is going to be a competitive differentiator for brokers, so they're going to have to be on top of that," Bailey contends, noting that the various brokers will take different approaches as each decides which accounts are going to be eligible.

There also is the practical consideration of the infrastructure needed to operate a portfolio margining service. When it comes to technology, one of the big issues will be around risk management, says Bailey. That means "accounting for the different types of trades and what the actual risk is, and [calculating] what margin is going to be required for different types of trades" to be able to give customers a sense of their exposure intraday, he notes.

Technology Demands

As such, there are significant technology implications to the application of this rule change that will require firms to make investments in order to prudently manage the risk on a more real-time basis, says Fimat's Kloet. In anticipation of this, in 2005 Fimat bought an equity broker, PreferredTrade, that had a "proprietary bookkeeping system that has helped us get to a certain point in terms of being able to analyze position offsets," he notes.

"We've taken what was at Preferred and at the same time spent a good amount of time and effort building a proprietary portfolio value-at-risk analytic tool, which we use in the Fimat Group globally," continues Kloet. "We have clients that were using VaR analysis, where they are trading multiple products. Putting equities and equity options into the mix together is merely another product. We've been able to do that elsewhere in the world, and we've used this tool to do it."

Indeed, one of the technology requirements will be an integrated cross-asset class environment. "Many firms use a different trade-capture and bookkeeping system for their derivative trades than their cash market trades, so aggregating those trades at close to real time is a challenge," says Kloet. Firms will therefore need some form of data bus to transport data and ensure both sides of the trades are fed into the risk system on a timely and seamless basis, he notes.

Meanwhile, SunGard announced at the Futures Industry Association's Annual International Futures Industry Conference in March that its Margin Advisor solution is capable of supporting the margin rule amendments. And while there has not been much noise about applicable offerings thus far in the software fraternity, other companies are sure to follow suit, reckons Aite's Bailey. "This is going to be a very big opportunity [for the software vendors] as it gets put in place and as it expands," he says.

However, Fimat's Kloet thinks that while firms would be sure to look at any applicable vendor risk systems, the largest institutions are likely to want to "manage the parameters that go into such an effort internally," and so may not want to wholly rely on a canned package. Instead, "Many firms will choose a mix of proprietary and non-proprietary efforts," he says.

Then there is the question of what other steps may be taken along the road to greater portfolio margining efficiency. "What they've done on April 2 is by far the most comprehensive kind of approach yet, but it still doesn't include, for instance, fixed-income instruments as part of the rules," notes SIFMA's Quinn. "Obviously, that is a big part of lots of folks' portfolios."

Uncertain Futures

There also is the issue of incorporating futures into the regime. Securities and futures have different customer protection regimes, which makes it difficult to move a commodity futures contract into a securities account, and vice versa, explains Quinn. "Technically the rule says we would allow futures to be put into the account," he relates. "But currently there are regulatory and definitional issues associated with the SEC and CFTC [Commodity Futures Trading Commission] agreeing upon a format for combining futures and securities in an account."

Adding futures to the mix would, therefore, be a challenge, says Aite's Bailey. "But I think that's something that the expansion would eventually include," he adds.

For the moment, though, there are no concrete plans or timelines for such extensions to the regime. Rather, it is a case of building up experience with the current changes before contemplating the next steps, according to SIFMA's Quinn. "There is a general understanding that regulators are going to want to see how this works for a while before expanding it yet further," he says.