Produced in partnership with BNY 

Australian asset owners find themselves navigating a more volatile environment of rising geopolitical instability and more stringent operational and governance standards.

As a result, risk management and optimising liquidity has taken centre stage and derivatives are playing a leading role. They are being used for a range of purposes, including currency hedging, downside protection, or tilting the portfolio, according to representatives of several large asset owners who recently attended the Fiduciary Investors Symposium event in New South Wales in June.

“We have a large internal dynamic asset allocation program, which is mostly implemented through futures, but we are starting to think like others about a more considered approach to tail risk management,” one large asset owner . “A lot of that is motivated by the liquidity risk that large derivative exposure which we have introduced into our portfolio.”

Recent U.S. policies have accelerated several long-standing macroeconomic trends. The broad-based Liberation Day announcement of tariffs, and the resulting double-digit decline across equity markets that followed the tariff announcements has underlined the need for more strategic downside protection across portfolios.

Meanwhile, investor confidence in U.S. dollar-denominated assets is waning given the country’s twin fiscal and current account deficits, rapid policy shifts, China’s technological resurgence and Germany’s decisive fiscal stimulus.

The role of derivatives in risk management

All these geopolitical and market factors are now driving a renewed focus on currency as Australian asset owners increasingly invest offshore. FX derivatives account for the bulk of an estimated $900 billion held by Australian superannuation funds, according to the Reserve Bank of Australia.

The trends driving the use of derivatives are set to continue to evolve as asset owners look for more flexible approaches. According to a recent white paper published by the International Swaps and Derivatives Association (ISDA), “Australian Superannuation Funds: Current and Future Uses of Derivatives,” funds typically hedge fixed income, property and infrastructure investments fully against currency risk and hedge approximately one third of their equity investments.

“The next evolution for derivatives hedging is now underway given the industry has successfully navigated its way through the Uncleared Margin Rules (UMR) reform, which was rolled out over several years across regions by the G20,” said Mark Higgins, senior product manager of margin services at BNY.

UMR reform required counterparties in non-cleared over-the-counter (OTC) derivatives transactions to exchange initial margin (IM) and variation margin (VM). This consumed collateral that had previously not been required and added extra operational costs.

“The regulatory reforms appear to have stabilised a little bit – it’s no longer a counterparty risk play anymore – it’s a liquidity efficiency optimisation story,” he said.

“So there’s an opportunity now for everybody to take a breath around what they’ve been doing since 2022 and really take stock of how to do things better.”

Operational alpha and collateral strategies

This is the realm of operational alpha – incremental gains that can be earned through more efficient back-office functions such as treasury – an area that asset owners are increasingly focusing on in a less predictable market environment of volatile investment returns. One strategy that is now gaining traction offshore is to broaden the type of securities that are used for collateral, beyond cash.

“While cash remains the predominant form of collateral for variation margin, its share fell to 68.3 per cent last year – well down on its peak of 80.0 per cent in 2020,” according to Amy Caruso, head of collateral initiatives at ISDA.

As reported in the annual ISDA Margin Survey, the proportion of non-government securities grew to 13.8 per cent – the highest level in the six years that ISDA has surveyed VM composition.

“The survey showcases the trend that our members, such as pension and insurance companies, have been improving their non-cash collateral operations and also broadening VM Credit Support Annexures (CSAs) beyond cash as eligible collateral, with the ultimate goal of optimising collateral and better managing liquidity,” says Caruso.

This trend to use a broader array of securities as VM collateral provides greater flexibility for asset owners, although it has yet to take hold across the Asia Pacific region where the VM is still dominated by cash, says Cherry Li, head of liquidity and margin services, Asia Pacific, at BNY.

“This trend to use a broader array of securities as VM collateral provides greater flexibility for asset owners, although it has yet to take hold across the Asia Pacific region where the VM is still dominated by cash”

– Cherry Li, BNY

“The client demand is building and building,” Li says. “Eventually the dealers will have to accept more of this non-cash asset coming in as VM, and they’ll probably have to look at ways of being more efficient operationally.”

It means asset owners have a broader basket of collateral to use, and do not need to liquidate assets to meet collateral obligations.

For example, it may be more cost effective for an asset owner to deliver U.S. equities as collateral while holding other types of equities that can be used as part of their securities lending program.

The ISDA Margin Survey also reports that the participating global banks accepted $US325 billion in non-cash VM at the end of 2024, accounting for a record 31.6 per cent of the roughly $US1 trillion in total VM collected by dealers to cover changes in the market price of non-cleared derivatives.

A triparty agent configuration can streamline and optimise this process, including handling issues around pricing, settlement, corporate activity, and other corporate actions that are attached to more esoteric assets.

Higgins expects the balance of non-cash VM to increase over the next 6-12 months and while this will create greater operational complexity, it can be well managed via a triparty arrangement.

“It’s a proven tool for securities lending, repo, initial margin, and OTC VM is just next on the list. I’m aware that some banks need to modify their internal collateral management platforms to accommodate this at scale, but I do think this is going to happen,” said Higgins.

As Australian asset owners grapple with heightened geopolitical risk, shifting macroeconomic dynamics and regulatory frameworks, their approach to risk management and collateral strategies must evolve to unlock new efficiencies in their portfolios and to help them navigate an increasingly complex and fluid investment landscape.

A message from BNY:

BNY has recently announced the integration of its CollateralONE with LiquidityDirect^SM platform which allows clients to optimise collateral, improve liquidity, and streamline financing activities in one ecosystem. To learn more about BNY’s Margin Services solutions, please visit here.