Capital Optimization: Next Generation Best Execution

Insight
03/01/2021

Uncleared margin rules, or UMR, will dominate the conversation of buy-side firms in the same way that transaction cost analysis (TCA) and best execution gained prominence leading into and following the advent of MiFID II in 2018.

In September 2021, the steady creep of UMR into financial markets takes another step forward. The threshold drops to $ (or EUR) 50 billion as measured by Average Aggregate Notional Amount (AANA). This is a sizeable drop from the current $ (EUR) 750 billion and puts many more buy-side firms in scope. Further reductions planned for September 2022 will affect smaller buy-side firms with AANA of $ (EUR) 8 billion.

UMR will increase focus on AANA, creating incentives to monitor limits and maximize efficiency to enhance performance to the greatest degree possible. In short, capital optimization will become the next generation of best execution.

The search for opportunity
TCA helps buy-side dealing and execution desks optimize and streamline their trading processes by adding, or saving, crucial performance points for investors. Technologies and systems have been explored and integrated into the buy side, achieving cost savings, and supporting regulatory compliance.

Now, that same potential exists to enhance performance and realize cost savings by efficiently using the capital resources allocated to trading. The sell side, which has been subject to regulatory changes for some time, has largely embraced this concept. As more and more buy-side firms come into scope for UMR, it is their turn to focus on better workflow processes to help optimize the use of capital.

The business case for capital optimization extends beyond regulation, however. Although these firms have improved execution processes, these can be enhanced further to provide better access to deeper liquidity and reduce the actual cost of doing business – both for the firm and their counterparties. They can do this by reducing their gross or net notional outstanding, reducing settlement risk, and easing concentration risk among counterparties using techniques such as novation and compression.

Most importantly, embracing better workflow processes around the use of capital sees the firm reduce the line items in portfolios while maintaining market risk levels. The opportunity for returns is undiminished, but the cost of achieving them is mitigated by reducing the capital costs assessed against the desk.

Optimization becomes a pre-trade imperative
The good news for investment firms is that much of the optimization framework is already in place and available for adoption. Once manual and onerous, the process is now automated, proven and easy to implement. In fact, the technology is already being used by a large swathe of the sell side who represent a large proportion of any fund’s major counterparties. Adoption by the buy side creates further significant optimization benefits.

At many firms, operational efficiency has historically been viewed as a post-trade objective, but technological innovation creates opportunity for the trading business to embrace it in the pre-trade space. Where funds previously may have asked about the robustness of a liquidity stream or the ability to straight-through process after the trade, now they can ask about capital optimization before dealing.

Capital management and concentration risk remain critical
Technology can also help with the growing issue of concentration risk given the shrinking number of counterparties available to buy-side firms. Workflow solutions enable these firms to broaden their counterparty “panel” and alleviate the pressures of concentration risk; however, this can only be done in a collaborative fashion and requires a central ‘marketplace’ for sell- and buy-side firms to connect to help each other reduce their capital footprint. Whether through compression or by shifting exposures to regional banks with strong balance sheets and spare capacity, optimizing capital will be a significant focus for the buy side in 2021.

The good news is that such a shift involves less heavy lifting for the buy side than it might first appear. The increased automation of the trading business – most recently advanced by the increased use of algorithmic strategies and Software as a Service (SaaS) – means that often solutions are about connectivity rather than hardware. Mostly, a new mindset is required – one open to the opportunities afforded by the smarter use of capital as part of an operational shift, and willing to embrace new technology solutions to automate continuous optimization.

Traditionally this has been the domain of senior management or the back and middle office, but as sell-side traders can tell their buy-side brethren, UMR means capital charges allocated to the trading business have become something for everyone to focus on. Best execution is no longer about hitting the best bid and offer; just as smart order routers driving the algo strategies have shifted the relationship landscape for traders, so too capital optimization will change how they think and operate.

Whichever way one looks at it, the buy side is going to have to get serious about capital optimization. Fortunately, new technology solutions are available to help them.

Written by:
Capitolis
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