Uncleared Margin Rules - will you avoid the chaos?

• Uncleared Margin Rules (UMR) have been put in place globally to mitigate credit exposures and reduce systemic risk in derivative markets

• Firms are required to calculate initial and variation margin requirements on a daily basis

• Daily initial margin requirements must be supported by both the posting AND receiving of collateral which must be held in segregated bankruptcy remote custodial arrangements

• Costs associated with UMR compliance may affect the business models and investment strategies of newly in scope firms

• Phases 4 and 5 of UMR scheduled for September 2019 and September 2020 could bring into scope over 1,000 firms trading under nearly 10,000 legal agreements, requiring the establishment of up to 20,000 custodial arrangements

• Smaller firms may not have the experience, processes and technology to implement and manage daily margin and collateral processes

• Larger firms may not have the scale and efficiency to cope with the increased numbers of clients caught by phases 4 and 5

• Industry estimates based on the experience from the first three phases suggest implementation could take in excess of a year

Background – Uncleared Margin Rules

As a result of the financial crisis, in September 2009 the G20 agreed to introduce a range of regulations to make financial markets safer, fairer, more efficient and more transparent.[1]

In 2011 the BCBS and IOSCO were called upon to develop consistent global standards for the margining of non-centrally cleared derivatives[2] with the dual intentions of reducing systemic risk and promoting central clearing.

The resulting policy framework published in 2015[3] has been enacted into global legislation requiring derivative trading to be supported by the exchange of variation and initial margin[4]. The legislation has been phased in based upon firms’ aggregate average notional amount (AANA) of non-centrally cleared derivatives.

The first three phases up to September 2018 have affected a relatively small number of dealers and large, well-resourced financial firms. The introduction into force of Phases 4 and 5 in September 2019 and September 2020 respectively is on a different scale. ISDA estimates that up to 1,000 firms trading under around 9,400 legal agreements, requiring 18,800 segregated initial margin accounts may be caught in these final phases[5].

Furthermore, industry estimates suggest that the renegotiation of existing ISDA Master Agreements and Credit Support Annexes might take up to 3 months, and that the KYC due diligence and onboarding requirements of custodians potentially taking up to a year. Given the numbers of market participants looking for similar solutions in the same short time period, these estimates are not unreasonable.

The sheer scale of the numbers of firms caught by the final phases is likely to have an impact on the capabilities of dealers, custodians, vendors and service providers to assist firms in meeting their obligations in a timely and efficient manner.

Without the ability to both call and receive collateral to support initial margin calculations, parties will no longer be able to trade uncleared OTC derivatives beyond their relevant deadlines.

So understanding the implications of the phase in process for your business will be key to successful operational readiness

4 C’s for UMR Compliance

Complexity

Whilst the intentions, principles and schedules for the implementation of the Uncleared Margin Rules are internationally synchronised and arguably relatively straightforward to understand, the detail of the global legislation introduces a high degree of complexity in interpreting and implementing firms’ compliance solutions.

This complexity is multiplied for firms with multi-layered, multi-jurisdictional corporate, group or fund structures. Similarly, engagement with multiple counterparts is likely to lead to multiple different detailed requirements.

Cost

The adoption of UMR solutions will introduce new costs to firms, not only in terms of the cost of implementing new agreements, processes and technology, but also the ongoing costs to the business going forward.

Firms should undertake a broad assessment of the impact of costs on their business model. Such analysis should consider the effects on risk and financial resource management, the application of pre- and post-trade decision making and the incremental costs for custody and settlement.

Control

Uncleared Margin Rules impose ongoing control requirements on firms. The implementation of margin calculation models is subject to regulatory approval. Such approval requires amongst other things the demonstration of ongoing maintenance and back testing of margin models.

Trades, portfolios and valuations are subject to reconciliation requirements. Margin and collateral management processes are subject to eligibility and dispute resolution requirements. Firms must implement clear ownership and governance of these roles as part of their Target Operating Model.

Capacity

Smaller firms may have fewer resources to analyse, design, implement and run compliance solutions. Larger firms may have experience and resources based on the implementation of previous phases of UMR, but the prospect of negotiating, onboarding and testing with a proportion of the 1,000 newly in scope firms by September 2020 may prove challenging.

Organisations should be considering not only the resourcing required to execute on compliance but also the ongoing impact the obligations drive in terms of workload. Understanding how to support and scale the operating model to satisfy the new obligations is a critical success factor for safeguarding ongoing compliance.

Contact Ascendant Strategy to understand how we can help you navigate the complexity associated with compliance and ongoing management

Authored by Mark Croxon, Thamesbench Ltd, for Ascendant Strategy Ltd

[1] G20, Pittsburgh summit declaration, http://www.g20.utoronto.ca/2009/2009communique0925.html

[2] G20, Cannes summit final declaration, http://www.g20.utoronto.ca/2011/2011-cannes-declaration-111104-en.html

[3] BIS/ISOCO, final policy framework, https://www.bis.org/bcbs/publ/d317.pdf

[4] European Commission, https://eur-lex.europa.eu/legal-content/EN/TXT/PDF/?uri=CELEX:32016R2251&from=EN

US Prudential Regulators, https://www.govinfo.gov/content/pkg/FR-2015-11-30/pdf/2015-28671.pdf

CFTC, https://www.cftc.gov/sites/default/files/idc/groups/public/@lrfederalregister/documents/file/2015-32320a.pdf

NB The SEC reopened its comment period on margin rules for Security Based Swap Dealers in Oct 2018: https://www.sec.gov/rules/proposed/2018/34-84409.pdf

Uncleared Margin Rules – will you avoid the chaos?