This article was first published by Securities Finance time.

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Margin is the grease in the wheels of international capital markets, essential for the efficient functioning of the finance industry, yet it only grabs headlines when it creates knock-on effects elsewhere. A case in point was the experience of liability-driven investment (LDI) funds operating in the UK gilt markets in September 2022, when market events driven by the UK government’s mini-budget triggered a sell-off in this historically stable asset class. LDI funds found themselves suddenly needing to meet margin calls in cash which required them to sell their gilt positions into a falling market, creating a feedback loop which ultimately required central bank intervention to resolve. Processing backlogs, settlement cycles and staffing bottlenecks amplified the situation, disrupting multiple firms’ day-to-day operations for multiple weeks. One year on, we are seeing the market adapting as a result of the crisis. New solutions have been developed which allow firms to collateralise their margin calls more effectively in times of stress.

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UK mini-budget and its impact on the gilts market

On September 23, 2022, the newly installed UK government announced a range of economic measures and tax changes in the ‘mini-budget’. These measures surprised the capital markets and were interpreted as negative for the British economic outlook, especially for the public debt burden, which was projected to grow with no apparent or credible plan to fund the additional borrowing. Long-term UK borrowing costs rose by around 0.3 per cent in one day. The yield on the 30-year gilt rose by a further 1.2 per cent over the following three days. The unprecedented volatility had wide-ranging impacts, including on the pound which quickly sunk to its lowest value in decades, and in retail mortgages where interest rates surged to levels not seen since before the 2008 financial crisis. The political cost was high, and over the next few weeks UK government ministers were forced from office as the policy changes were reversed one-by-one in a series of U-turns from the governing party. Amid the initial volatility, LDI funds were subject to repeated margin calls on their derivative strategies as the market moves drove ongoing re-valuations in their interest rate swap portfolios. When gilt yields rise and their value falls, these funds must typically provide additional margin to their derivative counterparties to support both cleared and uncleared swap positions. At the time of the crisis the majority of funds’ collateral schedules required cash to be posted, with no option to use non-cash when fulfilling margin calls. The funds do not hold large cash reserves so are forced to sell holdings when the demand for collateral exceeds these reserves. The mismatch in collateral eligibility versus fund holdings triggered additional downward pressure on gilt prices as the LDI funds became one-way sellers in the market, a ‘feedback loop’ which — left unchecked — could have threatened the solvency of the entire LDI market segment. LDI funds selling holdings depressed gilt prices, raising the prospect of higher margin calls, requiring further asset sales to generate the necessary cash. The UK’s central bank stepped in five days after the mini-budget to backstop the market in long-dated gilts by buying assets to stabilise prices and end the cycle. Sarah Breeden, Bank of England’s executive director for financial stability strategy and risk, was quoted: “more widespread collateralisation has increased the sensitivity of liquid-asset demand to market volatility. And, if market participants are not prepared for such calls, their actions to raise cash can squeeze liquidity in already stressed markets, further amplifying shocks.”

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Preparatory actions on behalf of market participants can be addressed by using a two-part strategy applicable to firms on both the buy-side and the sell-side of derivatives markets: (1) extended collateral eligibility and (2) streamlined operating models.

Extended collateral eligibility in over-the-counter (OTC) markets can be achieved by extending the range of allowed securities in the Collateral Support Annex (CSA) of the International Swaps and Derivatives Association’s (ISDA’s) trading agreements. Where, historically, these had been limited to cash-only, a number of the LDI funds have undertaken the process of updating their agreements to ensure assets such as UK gilts, other highly-rated government bonds, or even corporate bonds are included in the eligibility schedules. This step will serve to make the market more resilient in the face of future volatility and provide firms with a larger collateral pool to source margin collateral from. However, it constitutes only a partial solution. To fully mitigate the risks, firms should also evaluate the sensitivity of their operating models to spikes in processing volumes. Streamlined operating models around margin processing have progressed significantly since the advent of Uncleared Margin Rules (UMR) regulations pushed firms to consolidate and automate workflows in the derivatives markets beginning in 2016. Many more opportunities for automation remain, and this was highlighted during the gilts crisis when a variety of manual processes were quickly overwhelmed by the volume of activity. Firms seeking to manage these risks while simultaneously reducing their balance sheet costs through optimisation can benefit from using a platform such as HQLA^X. The baseline capabilities offered by HQLA^X for Variation Margin enable clients to transfer the ownership of securities between each other at precise moments in time, 24 hours a day. Clients can choose to extend the automation around these flows by adding programmable behaviour in their own margin management systems or by working with HQLA^X partners. If an LDI fund and its derivative counterpart bank used the HQLA^X platform, the workflow could be automated. 1. Market moves generate a revaluation of interest rate swaps between the counterparties. 2. The resulting margin call is made from the bank to the fund (or vice-versa) through a shared margin automation service. 3. The margin service communicates the agreed call requirement to an optimisation service (multiple providers exist) which can select from the LDI’s available non-cash assets based on pre-agreed eligibility in the CSA. 4. The optimisation service instructs HQLA^X to deliver the selected assets from the fund to the bank, completing the workflow. This process can work in both directions and can be run as often as the counterparties require. It is feasible to complete the whole sequence in a matter of seconds, depending on the level of automation set in each system. The software and services necessary exist in production today, the legal models are proven, and integration can be accomplished using existing messaging networks to accelerate onboarding. Significantly, the same models could be extended to support initial margin both in the uncleared and cleared space. The cornerstone of the technology deployed by HQLA^X is the ability to mobilise collateral at precise moments in time. In the cleared space, the latency of the margin call and collateralisation process is critical, with cash calls being triggered if securities are not delivered quickly.

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Moreover, when a clearing house issues margin calls to its members who in turn may be required to issue margin calls to their end clients, the overall transaction chain may result in multiple movements of collateral and therefore trigger additional realtime reconciliation requirements. To mitigate the operational risks, many clearing members require clients to post a buffer of assets to them which, in turn, would be deposited with the clearing house to comply with asset protection rules under EMIR, for example. However, this is sub-optimal, particularly if the end client wishes to mobilise assets across different venues or jurisdictions or substitute positions frequently. Aligned with the model that HQLA^X has already rolled out to support variation margin, HQLA^X is working with market participants and leading clearing houses and CSD’s to extend this capability from OTC into cleared margin, enabling participants to move collateral quickly and seamlessly in and out of CCP accounts with minimal operational complexity. The result will lay the foundation for additional automation and optimisation opportunities, further reducing costs for clearing members and their clients in both the operational and balance sheet domains.

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