Arcesium
Himanshu Bagr and Ashley Bell
04 March 2025
Arcesium鈥檚 Himanshu Bagri, product lead, Treasury Suite, and Ashley Bell, vice president, Financial Operations, look at the importance of timely margin calculations when managing risk
Image: Arcesium
In 2021, Archegos Capital Management infamously collapsed after failing to meet margin calls, wiping out millions of dollars in market value in a few days. The family office, operating like a hedge fund, had taken on hidden leverage via derivatives that created significant risks for its counterparties. This included prime brokers, such as Credit Suisse鈥檚 US$5.5 billion hit when Archegos failed to meet margin calls during a sharp market downturn.
Its founder was recently sentenced to 18 years in prison for using complex derivatives to secretly build massive, undisclosed stock positions and engaging in a sophisticated market manipulation scheme that ultimately caused billions in market losses and destabilised multiple financial institutions. The episode highlighted the dangers of leverage and poor risk management, as well as the ensuing impacts that pose dangers to financial stability.
Economic uncertainty calls for vigilant treasury risk practices
The Financial Stability Board (FSB) warned that non-bank participants must be better prepared to endure times of market stress and crises when sudden increases in margin and collateral requirements are sometimes significant in scale and frequency. The pandemic era introduced the greatest market and economic disruption in the United States since the 2007-09 financial crisis. Since then, calamity has become the rule and not the exception.
In 2024, the Federal Reserve promised seven rate cuts and delivered three. Experts are now forecasting only one cut in 2025. The treasury yield curve has been uninverted, for now. Recessions historically follow an inverted yield curve, usually within a 12 to 18-month window. Economic uncertainty calls for vigilant treasury risk practices 鈥� as does geopolitical uncertainty.
Margin call volumes spiked during Covid-19鈥檚 early days. Extreme commodities market movements followed Russia鈥檚 invasion of Ukraine in 2022. At that time, the European Association of CCP Clearing Houses, along with industry groups for the energy industry and traders, warned of "intolerable cash liquidity pressure" for energy companies hedging their risks.
Just last August, the CBOE Volatility Index (VIX), aka the 'fear gauge', soared to 65 (it was 82 when Covid emerged) when hedge funds borrowed low-yielding yen to buy higher-performing assets. Investors were concerned that sudden deleveraging would cause stocks to fall globally. While the panic did not portend catastrophe inequities, bettors against volatility suffered, as investors in 10 of the biggest short-volatility exchange-traded funds saw US$4.1 billion of returns erased from highs reached earlier in 2024. Many experts observed that perhaps the market dodged a bullet in this inscrutable episode.
Volatility comes from all directions, even from those betting against it. As the new US administration takes office, a new level of disruption is not impossible to imagine. Firms must be ready for anything.
The FSB advised regarding liquidity risk management practices:
Market participants should incorporate the assessment of liquidity risks arising from margin and collateral calls in their liquidity risk management and governance frameworks.
Market participants should define their tolerance for liquidity risk arising from margin and collateral calls and establish contingency funding plans.
Market participants should regularly review and update their liquidity risk framework.
Margin replication for optimal treasury risk management
Margin replication, executed in-house, gives your treasury department the power to predict the margin calls before they are received and enables them to estimate the margin impact of upsizing or downsizing existing position movements. Managers who can execute in-house margin replication can reduce the reliance on counterparties鈥� margin calculations. They then have more control over their collateral management and cash instead of giving it to counterparties. This allows them to recover a lot of excess margin calls and reduce the risk to counterparties.
In 2008-09, the subprime mortgage crisis had firms liquidating the quickest thing they could in a fire sale of equities. A domino effect exposed real inefficiencies in the market in which equities were being bought and sold for higher and lower prices than what they should have been. Firms with a lower unencumbered cash ratio had to liquidate positions, taking losses. A margin replication mechanism enables managers to mitigate losses by having transparency into where to move positions 鈥� without incurring a loss or penalty. Firms can then avoid selling assets under unfavorable market conditions, protecting portfolio value.
Strategies to mitigate counterparty and collateral risks
Reducing exposure and counterparty risk is another practical value-add of margin replication. Margin replication gives funds visibility into what the collateral movements should actually be, so they can claw back the overestimated margin to reduce dependence on the least advantageous counterparties. A hedge fund heavily reliant on a single broker or clearing house for margin financing may face sudden demands for additional collateral if the counterparty tightens credit terms.
In 2008-09, a lot of brokers were forced to reevaluate how much leverage they were willing to extend because they were collapsing. Funds should negotiate provisions like lockups and cross-margining agreements to reduce the risk of sudden collateral demands. With good lockups in agreements, companies have time to figure out their next moves, renegotiate agreements, or move positions to diversify counterparties and assess their creditworthiness. A manager鈥檚 ability to produce another option during volatile events is critical to maintaining stability.
In addition to mitigating counterparty risk, funds should have access to proprietary margin attribution through which they can track capital consumption at a manager or strategy level, thereby providing greater transparency to asset managers.
Margin simulation capabilities through APIs can model hundreds of different scenarios 鈥� such as shocking existing portfolios or creating new portfolios to estimate margin requirements 鈥� which then feeds into firm-wide risk management practices. Slowly and steadily, this is no longer just a use case for middle and back office-focused functions 鈥� the front office is also finding these margin simulation capabilities useful too.
Practical approaches to margin simulation and optimisation聽
Self-directed margin replication bolsters firms鈥� risk management postures. Treasury managers with the capability to run precise margin simulations for a daily view into position-level margins elevates firms to a superlative level of risk management. During the Russian invasion of Ukraine, when the energy markets were behaving erratically, we at Arcesium were running margin simulations for a client every day for a year because the energy portfolio had to post billions of dollars in collateral to maintain its trading positions.
The FSB is calling for 鈥渓iquidity stress tests to cover a range of extreme but plausible scenarios, including both backward-looking and hypothetical scenarios鈥�. Margin simulation can enable asset managers and hedge funds to do just that. These calculators can understand the potential impacts of certain transactions or position movements by running daily what-if analyses on existing or hypothetical positions with production or hypothetical margin calculators.
There was a sell-off on Wall Street on the heels of the 10 January jobs report and rising treasury yields. A larger market correction could have resulted in increased margin calls for equity derivatives and collateral shortfalls. Hypothetically, a 15 per cent depreciation of a foreign currency can happen, leading to higher margins for FX derivatives and cross-border positions. Hypothetically, inflation spikes and the Fed enacts a two per cent rate hike, stressing leveraged bond positions. A fund鈥檚 liquidity can be threatened in numerous unforeseen ways.
A tenuous path to a soft landing calls for proactive liquidity preparedness
Market participants now do business in an economy in transition. The US December 2024 jobs report surprised economists with an employment gain that exceeded forecasts by an astonishing 100,000 jobs, giving the Fed a lot to think about in considering its plan to lower interest rates twice in 2025. A positive yield curve, much less a normalised one, is not guaranteed. Any spike in inflation or other portents of a recession can lead to rapid rate increases. Higher rates can leave a hedge fund鈥檚 counterparties dealing with fluctuating derivatives positions and therefore may seek higher margin requirements.
Margin replication and simulation go a step beyond the liquidity preparedness recommendations of the FSB. Firms that can remain agile when facing unexpected collateral and margin calls will be the ones that have installed more effective liquidity risk management governance. Funds can execute what-if margin analyses to test moving positions around counterparties to optimise margin requirements, further reducing their liquidity strain. In our markets and economy, question marks have been outnumbering full stops.
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