In particular, circumstances surrounding the UK’s exit from the European Union
could prove the most challenging obstacle for the exchange, with clearing services for all of its EU-based members in question after March 29
In addition to Brexit, the LME has readdressed its clearing strategy and transparency requirements in response to the EU’s Markets in Financial Instruments Regulation (MiFIR) and the updated Markets in Financial Instruments Directives (MiFID II), affirming a greater emphasis on both indirect clearing and its transition to the Value at Risk (VaR) margin model.
First introduced in November 2017, the indirect clearing format holds ‘indirect clients’ in a chain of back-to-back exchange-trade derivatives contracts – in other words, a client of a client of a category I, II or IV clearing member – segregating positions and assets across the contract chain.
Indirect clearing enables exposure to the economic terms of the cleared contract from the end-client all the way up to the Central Counterparty (CCP).
“Indirect clearing could be just the thing to enable EU clients to access the UK market after Brexit,” LME chief financial officer Catherine Lester told delegates on Thursday.
“It is worth noting, however, that EU clients and indirect clients are somewhat dependent – in terms of treating that contract as a futures contract instead of an OTC contract – on the LME attaining trading venue equivalence post-Brexit,” she added.
Volatile markets spur margin change
In tandem with the exchange’s regulatory challenges, however, the LME has decided to adopt a VaR margin model, subject to regulatory approval, moving away from Standard Portfolio Analysis of Risk (SPAN) parameters to stimulate market moves and better calculate profit or loss on individual contracts.
Developed in the 1980s by the CME and adopted by the LME in 1995, SPAN is a delta-based margin system that responds to changes in futures or underlying prices and volatilities across a two-day liquidation period for both exchange and over-the-counter (OTC) products, using the worst case scenario of a two-year and 10-year price history.
Frequently implemented across futures and options markets, SPAN looks at a combination of positions, calculating the potential loss of each combination individually before an eventual aggregation.
Yet with increased volatility in futures trading over the last year, SPAN’s ability to capture correlations between contracts has come under question, with gaps emerging in risk-scanning as well as increased complexities due to CCP offering new products and trading strategies.
“The VaR margin methodology, in essence, allows you to work out how your copper portfolio is used, for example, and to run it back over a 10-year period before deciding on a confidence level,” LME chief risk officer Christopher Jones explained.
“Crucially, that means you have a very clear price distribution that allows [the LME] to assume that because your copper contract moved by X amount in 2011, it can be margined today as if 2011 was going to happen again,” he added.
In this regard, the LME’s implementation of a custom-designed VaR model will adopt a more portfolio-based methodology, increasing efficiency through an assessment of all positions in a portfolio.
Is VaR the answer?
Over time, VaR methodology could offer a more accurate assessment of future losses through a deeper risk-scan and loss calculation.
In simpler terms, while SPAN assesses the worst-case loss across a fixed set of 16 historic scenarios looking at future prices and option volatilities, VaR assesses around 1,000 historic scenarios, including correlations across expiries and different products, with initial margins changing over time as a result.
“There are efficiencies to be had when moving from a SPAN methodology to VaR, particularly if you have a spread-based portfolio,” Goldman Sachs executive director Sarah Shore explained, speaking on the LME Clearing panel.
“As a risk-manager at Goldman Sachs however, I’ve always said that when moving to VaR one of the key things we need to be paying attention to are the correlations that we’re embedding in the methodology, and making sure those have not only a historical, but an economic basis,” she added.
Yet from a brokerage perspective, VaR is not without its disadvantages, despite clients benefiting from the model’s potential to lower margins and potentially increase volumes off the back of spread positions.
“If the LME switches to VaR, we as a broker will also have to make that switch,” Nanhua Financial UK’s chief executive Nong Yan, who was also sat on the LME Clearing panel, told delegates.
“Whether a broker wants to pass that methodology onto a client is really dependent on a case-by-case assessment. From my perspective, we have clients that trade a large variety of products and VaR could benefit them on the basis of greater credit lines,” Yan said.
“Clients that trade a single product, however, very much need a single, short-dated system and may certainly be opposed to the change to VaR,” Yan concluded.