Margin Models Revolution: The impact on Risk Management in Energy Markets

Ben Hillary – Commodities People:

Hello, everyone. If you'll just bear with us for one moment, we'll just allow a few others to arrive.

Okay, excellent. Well, hello, everyone, and welcome to today's webinar “Margin Models Revolution: The Impact on Risk Management in Energy Markets.” My name is Ben Hillary, Managing Director of Commodities People. And yeah, really, a huge, huge thanks to everyone for joining us today.

Really, really pleased to see how much this webinar has attracted the attention of the industry with over 550 registrants from all corners of the globe and all parts of the energy trading ecosystem.

So in the next hour, we'll be conducting a really deep dive into some of the most pressing changes and challenges facing the industry when it comes to liquidity and risk management, including margin model changes, margin calculations, stress testing, and much more.

The goal of the webinar really is to help you, the viewers, understand how the landscape is changing, how the industry is reacting, and how the right use of technology can streamline your real-time risk management capabilities.

Some of the topics we’re covering today include what major changes in margin calculations we've recently seen and what the further potential amendments could look like, how firms navigate liquidity risk during periods of high interest rates, how stress testing has changed in light of recent geopolitical events, and how your organization can benefit from new portfolio margin models.

We've got a really, really brilliant lineup of speakers today, so I’m particularly delighted to welcome Nancy Gao, Derivative Control Manager at Petroineos; Andrey Shutov, Risk Advisory Lead in Commodities and Energy Trading at Baringa; and Adrian Carr, Product Manager for the Risk Platform at Nasdaq. So thank you all very, very much for being here.

The webinar will take the format of a panel discussion, followed by Q&A. So on that note, throughout the webinar, please be posting your questions in the Q&A box at the bottom of the screen, and also upvoting others of interest.

Do also make full use of the chat channel for any comments you want to share with the panel, with the audience, or even just to say hello, introduce yourself, and where you're dialing in from.

So without further ado, let’s begin. Firstly, if I could ask each panelist to please introduce yourselves and your interest in this topic. So if we start with you, Nancy, and then Andrey, then Adrian.

Nancy Gao – Petroineos:

Hi, everyone! I’m delighted to be invited for this discussion panel. My name is Nancy Gao. I’ve been working for energy trading companies, various companies, for the past 20 years. My recent company, which I work for, is Petroineos, and under the risk control team, I’m the Manager of the Derivative Control.

The reason I believe I’ve been brought up in this panel is basically because Petroineos has recently set up a project looking at margin management systems and how to best perform in our margin management. I would like to share some of our experiences and also look forward to hearing from others about how other companies deal with margin management.

Andrey Shutov – Baringa:

Hi, my name is Andrey Shutov. Thanks for having me on this panel. I’m working with clients in the commodities and energy trading space, and our risk advisory team has recently helped a number of clients set up liquidity risk frameworks, helping navigate through margining crises.

Adrian Carr – Nasdaq:

Thank you very much. Thank you for being part of the panel. It’s a great privilege for Nasdaq to be sponsoring this event. My name is Adrian Carr. I’m the Product Manager for the Nasdaq platform, which we’ve been working on for the past 7 years now. It’s really exciting to have Nancy and Andrey join us today. Likewise, we’re very focused on the energy commodity space and just as much as Andrey says, trying to help firms work out how to alleviate the pressures of the unknown, of the stress and volatility within the market. Thank you, Ben.

Ben Hillary – Commodities People:

Excellent. Well, diving right in, the first question I’d actually like to bring back to you, Adrian. What major changes have we recently seen in margin calculations, and what further changes are expected from ESMA?

Adrian Carr – Nasdaq:

Yeah, thank you very much. Changes are afoot, and changes are many. We’ve seen CME move from the old SPAN—what I guess in those days was called SPAN 1—to SPAN 2. So, you know, they went live last year with that. ICE is still going live at the end of this quarter with IRM 2, which again changes the margin methodology from a SPAN-type model into a VAR-based model.

You've got the Japanese Stock Exchange, which did so as well last year. Euronext—we’re working with them closely at the moment—they’re moving as well towards a VAR model. And I guess these changes are essential for the markets. They provide benefits to the participants of the markets because they allow for portfolio offsets for correlated products. So what they’re trying to achieve here is move towards a more mature, more modern model, which essentially helps their end users. So if you have a correlated product and you are trading with one another, those offsets can be recognized at an exchange, which hopefully, essentially, will do what it’s supposed to do, which is lower the initial margin required by a member or indirect member to trade on that exchange. So it should be something that we see is going to help in the future.

The changes are quite technologically advanced. In the old days, you would consume a SPAN file, and maybe if you were trying to mimic or replicate the margin of a CCP, you could have a SPAN 2 license downloaded, PC SPAN, sorry, a PC SPAN license downloaded on your laptop, and you’d be able to assess the rough estimates of the initial margin you could be prepared to pay. It’s a little more challenging now. There are multiple files involved because they’ve moved towards a VAR-based methodology. So there are multiple files involved, which obviously brings technological challenges. And hence, you know, the need for potentially a vendor out there who supports this is beneficial.

In terms of what ESMA are doing, we saw a press release a few months ago. ESMA are trying to assist the market by making these margin models change in a more effective and quicker manner. So in the past, the way it would work as a CCP, you inform the market that you wish to change your margin models. You have a meeting with your regulators, you’ve got to really prove and explain how your margin models are going to benefit the market. And that process can take a while, many, many months. And it can be a lot of back and forth as well. So ESMA are facilitating the market here by announcing a few months back that they are going to, in the near future, deem it possible that a new margin change will take no longer than 6 months. So we will essentially see more markets evolving, we will see more people changing. But it will bring benefits to the market. It’s going to lower initial margin throughout the industry. And if you are trading on a single exchange, that would bring benefit to you.

Ben Hillary – Commodities People:

Thank you for that, Adrian. Next question, I’d like to direct in Nancy’s direction. Can you explain how the exchanges implementing new margin models impact traders' strategies and risk management practices?

Nancy Gao – Petroineos:

Hi, this is Nancy. So I will take up this on this topic. Before I start, I’d like to give a bit more background on Petroineos. I need to mention what the portfolio we're currently trading, and because of that, the impact on our applying this new margin model. So for Petroineos, we’re trading crude, refining products, gas, power, emissions, and all energy-related products overall.

So our portfolio, in the way you look at what we are trading, maybe I’ll give two examples to give you some more idea of what we think about these new model changes and what our traders' strategy is. For example, the TTF contract, which you can trade on ICE, CME, and ECC as well. All three of them are using different margin models. ECC is a more pure SPAN 1, whereas ICE is the first one to start moving to the VAR-related model, and CME also followed up. Although they call it SPAN 2, I would say this SPAN 2 is a kind of SPAN plus, which has some VAR calculation as well.

So the strategy for us, when looking at these, is when you move from SPAN more towards the VAR-related one, we feel the sensitivity from the spot month on the margin will change far more frequently, as Adrian mentioned before. The changes in the margin rate we expect will be far more frequent on the front end than before. And because of that, we also need to compare the TTF example on all these three exchanges. They all have their own different portfolio pools. ECC will be more pure energy, whereas CME and ICE will be more combined. So because of that, when the market is rising, we will look at the behavior of the margin rate on all three exchanges, and when the market is less volatile, what the margin rate behavior will be, which helps us decide which exchange we prefer to trade on.

For products like Brent, which trade on CME and ICE, they are cash-settled products. For these cash-settled products, our trader may be more interested in inter-commodity credit offsets. So if our trader is looking to trade Brent versus WTI, they will likely lean towards the CME market, although ICE also has WTI. But overall, looking at market liquidity plus inter-commodity credit benefits, it leans more towards CME rather than looking at the new model impact on the front.

I hope that gives some insight into what we think about the new model change and our trading strategy. But different companies have different approaches. Principally, I would say for Petroineos, we are an NFC-minus. So OTC transactions versus exchange transactions have certain limitations on us, and we need to play all these into our trading strategy to make the final decision where we want to act.

Ben Hillary – Commodities People:

Thank you for that, Nancy. Well, following up on that, if we go to Andrey and then to Adrian, what technology solutions are available to help with the new portfolio margin model from global exchanges?

Andrey Shutov – Baringa:

There are different technology solutions available to help with the new portfolio margin models. To simplify things, I would distinguish between three types of technology solutions: margin calculation tools, risk analytics and risk management tools, and tools for margin optimization.

Margin calculation tools are software that calculate margin requirements based on predefined formulas provided by exchanges, including the new portfolio margin models. These tools should accurately replicate margin calculations and consider factors such as asset correlation, volatility, position sizes, portfolio concentrations, etc., and aggregate at a portfolio level to determine margin obligations.

Risk analytics and risk management tools provide traders with insights into portfolio risk under the new margin models. These often include functionalities like scenario analysis and stress testing, risk attribution, and regulatory compliance tools to assess the impact of new margin rules on portfolio performance and allow for more efficient use of capital.

Margin optimization tools help traders optimize their portfolio to minimize margin requirements while maintaining desired risk levels. These tools use optimization techniques to allocate capital across different assets or strategies, or between different exchanges. Advanced portfolio management systems can also assist in monitoring and rebalancing the trader’s portfolio, offering real-time portfolio tracking, risk assessment, and further optimization capabilities.

Adrian Carr – Nasdaq:

Picking up on what Andrey said about margin optimization, as a technology provider, that is something we’re working on with our clients. We built a risk system which is a real-time platform. The users started giving access to the platform to their treasury teams because it replicates initial margin in real-time. Then they started giving access to their traders to see how much initial margin and capital they are responsible for.

We are working on a margin optimization tool at the moment. We have energy traders asking if they execute a trade, where would be the best place to put it. So we have a “what if” tool that goes to different exchanges, and the system tells them where they would see the best portfolio offsets. We are also working with our AI team to tailor our system to suggest the most optimal execution from a capital perspective, reducing the need to borrow money in a high-interest rate market.

Having a system that replicates initial margin is fantastic, but you also want to understand your firm’s cash flow at risk. So, alongside initial margin, you need real-time intraday option analytics, recalibrating volatility services, theoretical Greeks, single-factor shocks, etc. Having all these in a single view allows firms to assess their overall cash flow risk.

Ben Hillary – Commodities People:

Excellent. And Nancy, how challenging is it to adopt the new margin methodologies?

Nancy Gao – Petroineos:

In general, it is quite challenging. There are many tools in the market providing help, but for us, as a company, we are interested in understanding the exchange’s SPAN file, their calculations, etc. However, the stress testing and liquidity models used by exchanges are somewhat of a black box. Despite claims of clear, robust, and transparent methodologies, we find it challenging to understand exactly how they perform stress testing and act on discrepancies. This is something we wish was more transparent and hope market solution tools can help clarify.

Ben Hillary – Commodities People:

Thank you. And Adrian, how can you get more visibility on initial margin requirements?

Adrian Carr – Nasdaq:

To Nancy's point, it is challenging. From a regulatory perspective, every CCP has to provide a tool allowing members to replicate or understand their initial margin amounts. These tools are available, but the challenge is in breaking down the details, especially when you're a member of multiple exchanges worldwide.

As a technology vendor, we have become an independent software vendor (ISV) at over 40 exchanges globally. We replicate the initial margin for our clients by consuming SPAN files or larger parameter files and accessing the necessary documentation. This allows us to provide real-time visibility into initial margin, delivery risk, concentration risk, etc., giving firms a full view of their risk profile.

Ben Hillary – Commodities People:

Excellent. Thank you. Well, I think this brings us to our first poll. The question is, do you foresee portfolio margin optimization as something your firm would benefit from in the future? Yes or no.

[Poll Discussion]

Ben Hillary – Commodities People:

Well, in that case, let's show the results. Okay, so probably not too much of a surprise. 95% see it as something they would benefit from.

Nancy, from your perspective, what benefits do you see in new portfolio margin models?

Nancy Gao – Petroineos:

The new models from the exchange, both ICE and CME, have been introduced with the aim to prevent shocking margin rate increases like those seen in 2022. We hope these new models, with their consideration of liquidity risk, will help prevent sudden and significant margin rate changes, thereby helping us manage liquidity risk better.

Ben Hillary – Commodities People:

Thank you. Well, how do firms navigate liquidity risk during periods of high interest rates, especially in markets where margin requirements are subject to change?

Nancy Gao – Petroineos:

Using the 2022 events as an example, our company implemented margin management tools to monitor real-time margin and set limits for each desk. If a desk reaches 70-80% of their margin limit, alerts are set up, and discussions with traders ensue to consider adjustments. We also have a margin funding allocation calculation, where traders are back-charged on a certain rate for margin usage, influencing their trading behaviors. We perform frequent stress testing to assess the company's cash flow and working capital, ensuring we are well-prepared for liquidity risk.

Ben Hillary – Commodities People:

Excellent. And Andrey, what are some best practices for firms to assess and manage liquidity risk in environments of high interest rates and changing margin models?

Andrey Shutov – Baringa:

The key elements for assessing and managing liquidity risk include establishing transparency, understanding liquidity demands, and building a robust liquidity risk framework.

1. Establish Transparency: Accurately calculate and reconcile margin requirements, understand the drivers, and attribute margin to the responsible business lines.
2. Understand Liquidity Demand: Calculate required liquidity buffers using methodologies and tools to forecast margin requirements and future liquidity needs. Collaborate with the Treasury department to secure short-term funding sources.
3. Build a Liquidity Risk Framework: Lift liquidity risk management to the same level as market and credit risk. Implement governance, controls, and trading steering mechanisms like limits and liquidity cost allocation techniques. Establish an efficient collaboration between liquidity risk management, commercial functions, and supporting functions like Treasury.

Adrian Carr – Nasdaq:

The Financial Stability Board recently released a consultation paper on improving liquidity preparedness in the event of market shocks. They want firms to develop stress tests to withstand extreme market moves and improve liquidity preparedness. This ties into everything Andrey discussed regarding liquidity risk management and stress testing.

Ben Hillary – Commodities People:

Thank you for that. Let's turn once again to our audience for our second poll. The question is, have you changed your approach to stress testing based on recent geopolitical events? Yes, no, but we’re in the process of, or no, unsure.

[Poll Discussion]

Ben Hillary – Commodities People:

Well, the results show that most are either yes or in the process of changing their approach to stress testing.

Nancy, how have recent geopolitical risks impacted your approach to stress testing?

Nancy Gao – Petroineos:

We definitely do stress testing. Our current margin management has two approaches: one based on preset market behaviors and another incorporating recent events into our scenario planning. The biggest impact for us has been adding margin liquidity risk into our stress testing methodologies since the events of 2022.

Ben Hillary – Commodities People:

Thank you. How do stress testing outcomes influence decision-making processes for market participants, such as adjusting trading strategies or portfolio allocations, and how does it affect your capital management?

Nancy Gao – Petroineos:

Stress testing helps us decide whether to trade OTC or on the exchange by understanding margin usage. It also influences our trading strategies and portfolio allocations by identifying vulnerabilities and opportunities for implementing more resilient strategies.

Andrey Shutov – Baringa:

Stress testing plays a crucial role in assessing how trading strategies perform under adverse conditions, identifying weaknesses, and making adjustments. It also helps in rebalancing portfolios to reduce exposure to assets sensitive to liquidity stress. Additionally, it informs capital management decisions by indicating the size of the required liquidity buffer to cover margin obligations during stress periods.

Ben Hillary – Commodities People:

Thank you. Well, we now come to the audience Q&A.

[Audience Q&A Discussion]

Ben Hillary – Commodities People:

We’ve had some really great questions today, but unfortunately, we're out of time. A huge, huge thanks to our panel for their insights and to the audience for joining. The webinar recording will be sent out via email within the next two days. Please share it with your colleagues and network. If you have any further questions, feel free to connect with us via LinkedIn.

A final question will appear once we close the webinar, and your response would be much appreciated. Thank you, everyone, and have an excellent day or evening ahead.