MARGIN MANAGEMENT

Broker Dealers, Central Clearing Counterparties face credit risk from their customers. Credit Risk Management measures the potential loss (risk). Margin (collateral pledged to the party facing the risk) mitigates the risk.

Margin requirements are defined by regulation for a range of exchange traded products; defined by Central Clearing Counterparties; or OTC defined by the Broker or Prime Broker for other transaction types.

Margin Management, outlined below, is the computation of the minimum collateral requirements. Margin does not fully eliminate credit risk, and instead is an input into a Credit Risk Management system.

• Regulatory margin includes Reg. T, FINRA 4210 (formerly NYSE 431), US Portfolio Margin (TIMS), IIROC, SPAN, Reg. U and others
• Central Clearing Counterparty is similarly proscribed margin and restricts acceptable collateral
• "House" which are margin requirements that are defined by the Broker Dealer and not regulatory. Methodologies vary greatly and can include rules based, Value At Risk (VaR), Stress Based, or variations of regulatory margin

Often a Broker Dealer/Prime Broker has more than one margin platform due to the wide range of margin computations. When customers have transactions serviced by two or more platforms:

• The customer is faced with multiple margin statements potentially in different formats
• Courtesy netting is operationally difficult

Risk offsets is problematic to compute

Flexible Margin Software

Features include:

• Pluggable architecture with modules for each of the regulatory, CCP and many common house margin methodologies (rules based, stress based and VaR based)
• New and specialized house margin can easily be developed and plugged into the architecture
• Modules that support Arranged Finance, collateral substitution, courtesy netting, risk offsetting and other complex workflows
• Highly customizable. Flexible handling by customer, asset class, security or strategy. Simple and compact specification of rules. Rules and exceptions rather than lengthy, time consuming and error prone entry of large amounts of information. Flexibility to use Excel-style expressions where need
• Powerful linear optimizer. Rules based margin, such as a portfolio of options under FINRA 4210, can be very difficult to find the lowest margin requirement. A linear optimizer is faster and can find 2, 3 and 4 option strategies (e.g., box spreads) that reduce the overall margin requirement of a portfolio. In extreme cases, by up to 95%
• Flexible and transparent reporting

Courtesy Netting

The customer may have a margin deficit in one margin arrangement (subject to a margin call) and have a margin excess in another (where the customer can request return of the excess). Overall, the customer meets the margin requirement, but margin has to be returned to the customer and the customer has to respond to a margin call - to meet the requirements. With supporting legal documentation, and a system that supports the operation - there is less operational effort, fewer transfers with the customer (lower cost and risk), and a customer that also sees these benefits

Risk Offsets

In many cases a customer will have transactions that are linked in value. If one loses money, the other will reduce the risk for the overall portfolio. Within one margin computation, offsetting is routine. For example, a customer FINRA 4210 has a lower margin requirement for a covered call (sold a call option on a stock held in the portfolio) than the total margin that would be needed the two positions separately. Offsets exist between different margin arrangements. One example from the long list of possible offsets are interest rates. Interest rate offsets on exchange traded bonds, OTC bond repos, exchange traded interest futures, OTC or CCP cleared interest rate swaps. While it is not possible to charge less than the regulatory margin, in most cases the Broker Dealer will have a house margin requirement that is greater than the regulatory margin. In this case, the offsets can be used to reduce the margin to the regulatory requirement level. The portfolio is less risky, so the customer can get a lower margin requirement

Prime Brokers tend to recognize more complex offsets including:

• Interest rate risk vs Credit protection
• Merger arbitrage
• Long/short portfolio

Additional Margin

While the above reduce margin for less risky portfolios, house margin requirements need to surcharge for more risky portfolios. Surcharges (also known as add-ons) include:

• Concentration risk - large concentration of a single position; or large concentrations of similar positions
• Liquidity risk - including position sizes that are large relative to the average trading volume of the security

Demo

For a given portfolio and set of rules there is one and only one lowest permissible margin. Many packages cannot identify this optimal amount. The following is a 17 S&P 500 options. Mix of long & short, put and call, different exercise dates and quantities (ranging from short 20 to long 1,000). The first pass, not shown, is to identify 82 unhedged, pairs (straddle and spreads), 3-sided (butterfly) and 4-sided (box) strategies.Not shown, but is straightforward. For example, using an in-memory SQL engine. Note: these positions for illustration purposes and are not the current S&P 500 options, strikes or current value of the S&P 500.

Fully unhedged, the margin requirement, the 4210 maintenance margin requirement is $46,427,500.

There is a "combinatorial explosion" that causes many packages to either totally give up - and use the fully unhedged requirement, or to have a solution that is far from optimal. The problem is that one option can be used in range of different strategies. Using it, for example, in a long box spread means that the option, and three other option positions cannot be used for another strategy.

The answer is a non-combinatorial optimization shown in the following video. The model, but not Excel itself, would be used for larger problems. The solution is captured in real-time and takes about a second to find the optimal, $312,500. This is 0.67% of the unhedged requirement.