Asset managers able to assess their exposure to uncleared margin rules can significantly reduce their administrative and trading costs.
In July 2019, the Basel Committee on Banking Supervision (BCBS) and the International Organization of Securities Commissions (IOSCO) announced an extension to the implementation of the margin requirements for non-centrally cleared derivatives, designed to stagger the process and give some firms more time in their implementation projects.
This followed a March 2019 clarification from BCBS / IOSCO that firms whose bilateral initial margin levels would not exceed the framework’s Ä50 million / $50 million initial margin threshold would not need to set up bilateral margin arrangements. Given the costs associated with the administration of these arrangements could be unnecessary, firms have been keen to establish whether they are still in scope – either at all or for a specific phase – and how they can minimise their costs as a consequence.
“Clearly margin is another cost which now needs to be taken into account in the trading of derivative instruments,” says Veeral Manek, head of product specialists at OpenGamma. “So, from that perspective this has added another layer of complexity, not only have firms got to think about the existing implicit and explicit costs which have been broker fees, commissions, taxes, etc. On top of the complicated bid-offer spread analysis they have now got to think about these additional margin costs.”
According to the original framework published in 2015, covered entities belonging to a group whose aggregate average notional amount (AANA) of non-centrally cleared derivatives exceeded Ä8 billion would be in scope for uncleared margin rules from 1 September 2020 onwards, based on March, April and May that year for Europe and every business day in that three month period for the US.
In the July announcement, that was pushed back to 1 September 2021, firms that have an AANA of Ä50 billion across March, April and May 2020 are now in scope from 1 September 2020 to 31 August 2021.
“The new phasing of UMR was welcome relief for many buy-side firms,” says Ricky Maloney, global head of buy-side fixed income and trading & clearing sales at Eurex. “I know of one firm whose exposure in terms of number of funds was more than halved. The change was widely known about before it was announced and it seemed to me that the buy side had confidence such an event would occur.”
It has helped firms who were already running late in the process, and that gives them more time to prepare for the potential effect on the costs of trading and investment.
“The smaller Phase 5 enables the industry to focus resources on a more limited set of clients who have to comply,” says Jack Callahan, executive director for OTC Products at CME Group. “There was already regulatory relief earlier this year for clients who had a large enough notional to be subject to UMR, but were unlikely to have an initial margin level above Ä50 million for any of their counterparties. Many of the clients in the new Phase 6 likely fell into that category, so they would not have necessarily had to go through with the full account set-up and legal documentation work.”
The imposition of uncleared margin rules (UMR) represents the last regulatory safety check on derivatives trading based on the 2009 Pittsburgh G20 Summit. At that event, authorities determined that derivatives trades ought to be centrally cleared and traded electronically where possible, in order to minimise the likelihood of one counterparty’s bankruptcy harming other counterparties.
Holding collateralised assets against the initial value of the derivative position (initial margin) and the changes in value of that position (variation margin) is intended to minimise the losses that a counterparty faces on a leveraged position in the event the counterparty defaults.
In a cleared trade that collateral is held by a central counterparty (CCP); in an uncleared trade authorities considered it proportionate “to apply a threshold of Ä8 billion in gross notional amounts of outstanding contracts to the application of the initial margin requirements.” This applies at group level or single entity level if the entity is not part of a group.
“It’s important to note that UMR is applicable at the legal entity level, so the hedge funds with a single large master account tend to be impacted sooner, whereas the ones who allocate among many accounts will find those smaller accounts will have more time before they’re in scope,” says Callahan.
Holding collateral against uncleared trades does not prevent exposure to default; insurer AIG was nearly bankrupted in 2008 – and only subsequently saved by the US government – due to its exposure to an uncleared margin call, made by Goldman Sachs on an uncleared credit default swap (CDS) which AIG had written to insure against defaults in a collateralised debt obligation (CDO) which contained subprime mortgages. In that instance the US broker said its US$10 billion exposure would have been protected and “had no material direct economic exposure to AIG,” due to its purchasing of credit default swaps (CDSs) which insured against AIG’s default, rather than the collateral pledged by AIG.
The UMR rules do create a standardised approach to the use of margin, including the need for same-day transfer and segregation of initial margin, effectively ensuring it is held with a third party, such as a custodian bank.
Investment firms need to be mindful of the impact at an operational level – including the administration and paperwork needed to set up margin agreements – and at a trading level.
Liam Huxley, chief executive of Cassini Systems says, “As a first step, investment firms must test across their entire book, forecasting using standard initial margin model (SIMM) as they need to find the most beneficial initial preparation, and assess where there is sensitivity. The impact – beyond operational effects, custodian arrangements, and establishing collateral management and processes needed to handle margin and reconciliation – will be the possible drag on the fund.”
Where the European calculations to check if a firm is in scope uses three data points from the last business day of March to May for a given year, the US uses a daily average for those three months.
Running the calculation is an annual process for firms to check if they are in scope, typically managed at a fund level. The SIMM as set out by the International Swaps and Derivatives Association (ISDA) is typically used, but it should not be assumed that two firms will arrive at the same result.
“For those clients in jurisdictions where the Phase 5 measurement period is now March through May of 2020, they have flexibility in altering trading behaviour or the positions they carry so they can reduce their uncleared notional below the 50 billion threshold,” says Callahan.
If firms want to reduce their costs or move out of scope entirely, they need to make a full assessment of their current use of derivative contracts and look at the potential for cash, cleared or listed instruments to be used instead.
What is the scale of the collateral impact and how do funds handle that; do they use cash or other assets?” asks Huxley. “Does that create drag on the portfolio? After that, breaking down how trading and investment strategies are contributing to that (drag). Is it possible to re-balance the portfolio or to take different trading approaches? Can you forecast the attribution and use trend analysis to look ahead and see when capital impact will hit its highest peaks, and also look at legacy trades? Only then will you be able see where is makes sense to offset that Day One risk.”
Smart use of existing derivative portfolios can also help to offset trades, by backloading the legacy portfolios.
Callahan says, “If you’re above the notional threshold and you have billions of EM rate swaps you can backload those and potentially get below the threshold and give yourself more time before falling into scope.”
©The DESK 2019