The global financial crisis left a lasting impact on the institutional markets. A raft of reforms aimed at reducing the risk firms carried on their books followed, and seemingly no financial product was left unaffected. The Basel Committee on Banking Supervision (BCBS) and The International Organization of Securities Commissions (IOSCO) created one of the most significant rulings affecting financial institutions.
First announced in phases, the BCBS-IOSCO rules introduced new margin requirements (UMR) for non-centrally cleared derivatives. The committees announced five phases for implementation (later extended to six), with each phase targeting smaller market participants. The initial phases affected the interdealer market and required participants with Average Aggregate Notional Amounts (AANA) greater than $1.5 trillion to comply.
Phases five and six, which will go into effect in September 2021 and 2022 respectively, target firms with AANA lesser than $50 billion. The result is several smaller institutions, and buy-side firms now find themselves in the spotlight. How are these firms gearing up to meet UMR requirements, and can electronification help ease the burden?
Significant regulatory changes
UMR rules target non-centrally cleared derivatives. From an FX perspective, products under the scanner include FX options, NDFs, physical FX forwards, hedging trades, and swaptions. Phase six of UMR was scheduled to go into effect in September 2020, but the challenges wrought by the COVID pandemic resulted in a year’s extension.
Phases five and six have long been identified as the most challenging ones, thanks to the size of affected participants. Smaller insurance firms, banking groups, and asset managers will be affected, and given their relative lack of resources, meeting UMR requirements will be tough.
“Resource constraints at smaller firms are part of the challenge, but there are other factors” , says Bob Stewart, Executive Director of Institutional Trade Processing (ITP) at the Depository Trust and Clearing Corporation (DTCC). “Phase five saw approximately 300 firms in scope which is more than in total for the previous four phases. All of these firms were calling vendors, custodians and counterparties in order to initiate reasonably complex risk-based exposure calculations, collateral account set-up, and legal documentation processes in much bigger numbers than before.”
Stewart also points out that working from home during the pandemic posed serious challenges. He believes Phase six will present even bigger challenges. “Phase six impacts buy-side firms with more than $8 billion average aggregate notional amounts (AANA), will see even more firms in scope (potentially up to 750 globally), and in this case, these are smaller firms who will tend to have less resources”
“Since Phase six impacts smaller buy-side firms with typically less middle- and back-office resources, these firms need to understand quickly what their requirements are and plan accordingly”
Bob Stewart
Broadly speaking, firms must implement Variation Margin (VM) and Initial Margin (IM) requirements on all their trades. VM is an established concept that is calculated from the market value of trades. However, IM is a new requirement that is a risk-based calculation and also includes a requirement for collateral segregation. Market participants will now have to identify in-scope trades, calculate the IM needed (both to post and receive), potentially source new collateral types and segregate any collateral exchanged.
Firms must also confirm the counterparties with whom they’ll need to interact. Institutions will need to create segregated margin accounts with unaffiliated third-party custodians and negotiate control agreements. Affected firms will need to execute these steps well in advance since custodians have deadlines of their own to complete the onboarding process well ahead of the UMR cutoff date.
In addition to this, firms will also have to install systems and processes that ensure IM is adequately calculated and transferred to all counterparties. UMR will likely strain the resources of most buy-side firms, given that the majority of collateral management and transfer processes are executed manually currently.
“Since Phase six impacts smaller buy-side firms with typically less middle- and back-office resources, these firms need to understand quickly what their requirements are and plan accordingly” Stewart says. “Buy-side firms may want to perform their own high-level analysis of AANA ahead of their regulator’s mandated observation period, since this will give them a head start.”
Staffan Ahlner, Global Head of Collateral at State Street, echoes Stewart’s views when queried about the resource challenge facing firms in scope for Phases five and six. “Yes, our strongest recommendation is for firms to start now, if they already haven’t! Firms will face challenges across five areas: Documentation, data, analytics, transformation, and workflow.”
For instance, custodians currently manage multiple segregated accounts with dual sets of instructions to manage collateral release. It might be 2021, but most sell and buy-side firms still use fax to communicate release messages. The work-from-home situation imposed by the pandemic threw these processes into chaos since most employees didn’t have access to faxes from home. The result was elevated rates of collateral settlement failures.
“There are two types of third-party segregated accounts – one of these is a fully-managed service offered by tri party agents, and the other is a simpler service based upon instructions sent by the pledgor to deliver or recall specific pieces of collateral” explains Stewart. “ Opening either one of these account-types at a custodian bank and making sure that your counterparty has all the relevant details can be a long process. It is fair to say that a significant number of Phase six firms will have no experience with these account structures or the associated messaging.”
UMR imposes even more challenging guidelines, and it’s unlikely that the current state of collateral transfer will cope. In highly volatile times, a lack of insight into the status of collateral settlement might cause even more problems, if firms don’t take corrective action right now.
Significant challenges ahead
UMR introduces a set of operationally intensive steps. It also adds workflows with which most institutions targeted in Phases four and five are unfamiliar. For starters, the IM calculation itself could prove problematic for most firms.
As Ahlner explains, “The challenge is the data coverage that is needed for the calculation. Depending on the trading strategies of the fund you could end up with a very broad set of instruments to calculate the exposure on. This is what will drive the data need.”
UMR regulation stipulates that firms can calculate IM using a schedule-based calculation or regulatory-approved model-based calculation. Firms have leaned towards a model-based calculation, with many favoring ISDA’s Standard Initial Margin Model (SIMM). This requires firms to choose a sensitivity level for all in-scope trades.
Each trade can have an average of 20 sensitivities, and with over 150 sensitivities applicable to exotic trades, the data-crunching required to execute this step is significant. Following this, firms must feed the sensitivities into the SIMM model which will give them the total IM exposure for the secured party and the pledgor.
“Firms will face challenges across five areas: Documentation, data, analytics, transformation, and workflow’.
Staffan Ahlner
In past phases, most firms initially neglected to calculate IM twice for each counterparty, and many expect this mistake to repeat itself due to process unfamiliarity. The SIMM model also introduces technical challenges. The model accepts files in a specific format, called a Common Risk Interchange Format or CRIF. Institutions must also evaluate whether their existing systems are capable of handling the burden that IM calculations impose.
From an operational standpoint, buy-side firms will not be familiar with the mechanisms governing tri-party segregation accounts when interacting with their custodians. Many custodian banks are reluctant to accept cash as collateral since it impacts their leverage ratio negatively.
Therefore, institutions will have to transfer securities. The result is a new can of worms for the buy-side or those unfamiliar with a non-cash collateral exchange. How will these securities be valued? How will incoming pledges be valued? How will collateral concentration be monitored?
Ahlner believes these processes will pose a significant challenge. “Firms need to perform SIMM calculation to determine the IM amount, and beyond that, they need to set up a segregation service, to both receive and deliver collateral. All derivatives trades need to be recorded and managed,” he explains. “Legacy systems may hold data in one format and transformation of data is required to fit into the utilities. Data needs to be accurate and timely produced every day.”
All of this is even before getting into the details of SIMM-model calculations and ratifying legal agreements between counterparties. Existing operation workflows will have to be revamped and stress-tested before the deadline. Firms should not underestimate the complexity of these new workflows.
For instance, every counterparty will have different collateral arrangements, with some falling under the UMR-stipulated threshold. Handling the exchange of margin, monitoring margin levels, and handling disputes are critical processes firms must define and design.
Technology will assist in implementing new requirements but the question of dealing with legacy systems is a tough one. Many collateral management systems (CMS) were not built to handle IM pledgor and secured margin calls. Integrating the IM calculation engine into the CMS is also a deeply technical process, one that requires considerable resources.
While most Phase four participants have reacted well, the relatively small size of the average Phase five and six participants has observers wondering whether resource constraints might prove a significant roadblock.
Neil Murphy, Business Manager at TriOptima says “In many cases, the ‘pain’ of UMR is magnified for smaller firms. Not only do they face the challenge of calculating IM, but in many cases they are starting from a disadvantaged position in terms of collateral – often characterised by use of legacy technology (in some cases Excel!) and low levels of automation – but they also face meeting the same requirements as larger firms, but often with far less resources.”
Electronification offers solutions and drives evolution
Given the complexity of these challenges and the real-time monitoring dynamic they introduce to operations, manual processes are unlikely to work. Automation is the key, and many firms have revamped their workflows accordingly.
With markets in an elongated bull run, cutting costs has become imperative for asset managers to boost returns, and outsourcing technical expertise has helped them revamp infrastructure cost-effectively. Vendors offer firms margin analytics platforms that bring transparency to the process. Traders can evaluate the margin implications of trade execution and post-trade costs before entering a trade.
From a post-trade perspective, analytics can be used to lower the overall amount of IM collateral required, while simultaneously keeping risk exposure constant.”
Neil Murphy
Murphy lists some of the advantages on offer. “Used ahead of trade execution, analytics may assist a firm to determine the best venue to book a trade (cleared vs uncleared), or suggest the optimal counterparty by considering any benefit of threshold utilisation, or size of overall IM requirement. From a post-trade perspective, analytics can be used to lower the overall amount of IM collateral required, while simultaneously keeping risk exposure constant”
Vendors such as TriOptima offer end-to-end UMR suites that help firms both calculate margin requirements and handle the downstream processes.. Central to this is provision of an IM calculator (including SIMM), dedicated margin call workflows and connectivity to Acadia for dispute resolution. Calls and collateral settlement are simplified thanks to real-time connectivity to Acadia’s real-time messaging and triparty instruction via SWIFT.
“With use of TriOptima’s triResolve service already standard for VM reconciliation, TriOptima partnered with Acadia to build a similar industry-standard platform to deliver IM reconciliation” explains Murphy. “In use across phase one to five firms, IM Exposure Manager (IMEM) provides an automated way to identify IM differences, whether driven by risk sensitivities or portfolio booking.”
Murphy also highlights that TriOptima clients using their collateral service, triResolve Margin, benefit from a single process that allows them to manage both VM/IM call workflows, combined with additional transparency to investigate and manage disputes via triResolve & IMEM.
ISDA also requires firms to demonstrate the applicability of SIMM to their portfolios by running benchmarks and backtests. Vendors have developed sophisticated backtesting methods that help firms quickly demonstrate applicability. They also automatically update SIMM models whenever ISDA releases a new version.
UMR has forced larger portfolio managers to view their holdings differently due to greater margin requirements. Costs are a factor here as well, and portfolio optimization analytics are in great demand. Some vendors offer machine learning-driven solutions that propose a set of trades to reduce or optimize portfolio costs.
For instance, moving trades from one counterparty to another might reduce position carrying costs and impact the overall portfolio in a certain way. These sophisticated engines help asset managers understand all the implications of the costs connected to their portfolios.
As UMR becomes a reality for the majority of the market, certain trends are coming to light. First, it’s becoming clearer by the day that many smaller firms impacted by the next phase are unprepared to handle the impact UMR will have on their businesses.
Managers who have adjusted to UMR regulations are now demanding greater access to data in the middle and back-office systems. The idea is to gain deeper visibility into the overall costs that their firms incur. The result is more demand for optimization algorithms and advanced analytics that help clients trade more efficiently.
Cloud migration is also on the rise, thanks to the desire for optimized costs. Scalable infrastructure with access to complex analytics is in high demand, and observers believe this trend will only accelerate.
“For many, the barrier to adopting or improving automation, has typically been the fractured state of technology – with firms using a myriad of systems to support the end-to-end process – and where replacement or upgrade to this process has been costly.” explains Murphy. “Fortunately, in recent years more and more tools have emerged which allow firms to move faster, and further, down the path towards full automation.”
State Street’s Ahlner puts it more bluntly. “It is not possible to do UMR without technology, and UMR is really an ideal opportunity to revisit the collateral strategy of the firm.”
Opportunity
The events of 2008 might have occurred over 13 years ago, a lifetime in the institutional FX markets, but their consequences reverberate to this day. UMR is a reality for institutional FX participants, and as more firms come under its purview, the degrees with which firms are prepared vary.
DTCC’s Stewart believes UMR presents a unique opportunity, as opposed to a huge hurdle. “Firms should view the introduction of Phase five and, next year, Phase six of UMR as an opportunity to introduce best practices to their collateral management processes, including increased automation. Not only will this bring operational efficiencies and help firms comply with the regulatory mandate, but it will also enable them to utilise their available collateral more efficiently, thereby reducing costs, risks and improving their overall capital and liquidity management capabilities.”