Abstract Tech

New Portfolio Margin Models Bring Benefits, but Also Challenges, to Risk Management

Malcolm Warne
Malcolm Warne Head of Product for the Nasdaq Risk Platform

This is the first article in a three-part series focusing on conditions and volatility in energy and commodity markets, and how trading firms and commodity brokers must assess the ongoing changes and impacts to risk management among numerous other macro and industry-specific factors that underscore their need for modern technology. 

Derivatives clearing has been on a long path toward evolution. The SPAN® calculation, first developed by the Chicago Mercantile Exchange (CME) in 1988, had ruled for decades as the standard for computing margin requirements.  

But now, new methodologies are being introduced just as energy and commodity markets are buffeted by persistent volatility, fueled in part by rising geopolitical tensions. In a high interest rate environment, these impacts are amplified and put further emphasis on efficient, intelligent risk management for energy traders and commodity brokers. 

SPAN 2 and new calculations go live  

The second half of 2023 saw CME implement its long-awaited SPAN 2 methodology, starting with energy futures and futures options traded on the NYMEX exchange. Initially delayed by COVID, the new calculation broadens the inputs that allow for more “granular and dynamic adjustments to margins at a product and portfolio level.” It carves out new categories for enhanced reporting of risk factors related to liquidity, concentration and market risk. This allows for margin calculations tailored to specific risk factors according to variables like seasonality and options term structure. CME’s plan is to roll out SPAN 2 for all commodities by the end of 2025. 

This news is joined by the coming introduction of Intercontinental Exchange’s Risk Model 2 (ICE IRM 2) to energy markets. The methodology, like SPAN 2, utilizes a filtered historical simulation to calculate margin while also expanding and refining the risk dimensions that feed into the equation. ICE U.S. equities markets have already transitioned to IRM 2, with energy futures and options processed through ICE Clear Europe are set to migrate to IRM 2 in Q2 2024. 

Portfolio margining can lower costs, but increase complexity 

The sum effect of these changes is a shift toward value-at-risk (VaR) calculations that assess portfolio gains and losses to get a fuller and more accurate picture of risk. VaR uses historical data over a defined lookback period to test portfolio P&L during potential market scenarios, with added calculations to model hypothetical events that may stress portfolios. Offsets are also built into the methodologies, in essence allowing margin requirements on one position to offset another within the same portfolio. The London Metal Exchange (LME), too, has committed to transitioning to VaR-based margining

The upside of new VaR-based margining is that more precise calculations can in some cases help firms lower their initial margin with all portfolio factors fully accounted for across products and positions. This ideally helps improve capital efficiency by right-sizing the collateral needed to satisfy final margin requirements, preserving liquidity amid high interest rates. 

The tradeoff, however, is that the complexity of these new calculations may strain the resources of firms, potentially adding to the costs of their day-to-day trading operation. For example, the original SPAN determined risk over 16 simplified market scenarios, whereas new methodologies can have over 1,000 inputs to reach an accurate and responsive determination of margin requirements. 

The value of risk insights 

The challenging landscape that energy traders and commodity brokers face is now made more complex by new VaR calculations. Spikes in intraday P&L and margin requirements driven by geopolitics and macro events can lead to increased margin costs for traders and credit risks for brokers—which are then amplified further in high interest rate economies. Firms that lack the necessary visibility into risk may be unable to keep pace with rapid market fluctuations. 

The operating environment calls for a full view into risk, plus capabilities to model in real time. That means having a solution that provides insights, transparency and analytics to be deployed across the book or client portfolios. Combining precise margin replication with real-time what-if calculations helps traders and brokers to mitigate risk while optimizing CCP funding requirements. 

Nasdaq Risk Platform is one such solution that’s empowering firms with tools to calculate and replicate margin in real time. Energy traders can use the platform to proactively predict and manage funding requirements, while brokers benefit from views across client accounts, enabling them to efficiently manage intraday house and client risks. And as a cloud-hosted, managed service, Nasdaq Risk Platform offers streamlined onboarding to help users realize value quickly and improve their risk management. Updating internal infrastructure to accommodate new margin models requires time and investment. Letting us do the heavy technology lifting allows firms to focus their resources on capital, liquidity and risk management while also benefitting from continuous, seamless updates. 

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