Bilateral OTC margining: marathon or sprint?
Bilateral margin requirements promise to change significantly the operations of firms within the uncleared derivatives market. There is no doubt that the future state will be dramatically different to the current market, but how urgent is the problem given the date postponement?
Canvassing market opinion, tier 1 banks seem to be relatively relaxed about the practical implications of proposed September 2016 changes, but more fidgety with regard to the broader catchment planned in 2017. There is even a school of thought that suggests we may be subject to further delay, as no final Regulatory Technical Standards (RTS) have been published. The race, however, has been on to create a market infrastructure capable of handling the new requirements and their iterations. We have seen utility providers gather, lose and re-gather momentum over the past year and now we are beginning to see the utility landscape firm up.
Our view is firms should enter the race early with a steady jog, to avoid a painful sprint later. The important thing is to have the finish line in mind, recognising there are many stages in the race. In this article we set out the bumps in the road, some of the emerging solutions that smooth the path, and conclude with our advice on top tips and techniques to be fit for the race.
Bumps in the road
We have heard much about the need to create a new market infrastructure for bi-lateral margining in the wake of proposed regulation by the Basel Committee on Banking Supervision (BCBS) and the International Organization of Securities Commissions (IOSCO). Counterparts will have to exchange Variation Margin (VM) and Initial Margin (IM) when trading non-cleared OTC derivatives. VM will need to be exchanged in the currency of the underlying swap or face a haircut. Maximum thresholds and minimum transfer amounts are required and as we have written elsewhere this is a departure from how the industry has operated historically. Dispute resolution is a major theme but lacks clarity particularly in relation to Margin Period of Risk (MPOR). It was generally accepted that MPOR would double if disputes could not be resolved as a punitive measure. At the time of writing, it isn’t clear whether this step will be made explicit within Bilateral Margin regulation.
Thankfully the regulatory deadlines have been split up and pushed out, giving everyone more time to prepare. The first bump in the road is the need for the big players to exchange initial margin (IM) on new non-cleared OTC trades from September 2016. This is a big change for the sell-side. Whilst they already exchange VM, they will now have to calculate, optimise and post significant quantities of IM cash or securities. One of the biggest challenges is how to avoid disputes in margin calculation, when historically every firm has used its own proprietary margin model, risk sensitivities and market data.
But just round the corner in March 2017 is the next speed bump, when variation margin (VM) becomes mandatory. The big players typically already exchange VM so no big deal there. However a new slew of firms will be included in the VM requirement, which is likely to have a greater impact on internal operating models, impacting STP, as well as the market liquidity as a whole. Financial Counterparties and NFC+ (as well as some of the larger NFC-) firms will be included, so a robust infrastructure for calling, agreeing and dispute resolution must be in place at that point. And in the run-up, rafts of new agreements and CSAs need to be negotiated and signed.
Due to the regulatory implications governing dispute resolution, it is strongly in the interest of firms to be ‘singing from the same hymn sheet’ to minimise the risk of disputes rumbling on. It is easy to see how an industry-wide solution would be preferable; this was certainly the aim of ‘Project Colin’, led by Goldman Sachs with backing from other affected firms. But Project Colin ran into the sand earlier this year, leaving a gap to be filled. Its replacement is Project Blazer, with an even wider consortium of industry backing, stitching together a range of service providers to form an integrated industry utility. AcadiaSoft is at the centre of the solution, and 13 banks have invested heavily in the AcadiaSoft led project. “Collateral Hub” as we understand the new utility will be called, looks to become the dominant player and has major attractions, particularly if adopted widely.
Each of the consortium players contributes particular function- ality that plays to their strengths:
- AcadiaSoft leads with their MarginSphere margin matching capability;
- TriOptima with portfolio and risk sensitivity matching;
- DTCC and Euroclear have pitched in with their Global Collateral joint venture, Margin Transit Utility (MTU), offering settlement instruction enrichment and delivery, and links to triparty infrastructure for security and speed of settlement
TriOptima is believed to be building a SIMM-based IM calculation engine that will be delivered and provided by AcadiaSoft. Following two small pilots so far, we hear 18 brokers will be involved in a wider pilot covering IM calculation, risk and reconciliations, starting October.
We like the AcadiaSoft solution but there are many complexities to consider. Each component in the integrated utility solution can be adopted independently, so firms must consider use cases where counterparts may have adopted all of the utility solution, or just one component. This calls for an “industry landscape” that sets out just how all the players will interact, not just for non-cleared, but for cleared OTC too.
The utility ecosystem
But Project Blazer isn’t the only utility in town. NetOTC has developed a bilateral IM solution that evolved from their original clearing platform strategy for multi-lateral netting of non-cleared OTC derivatives. Beyond standard two-way margining, NetOTC Bilateral includes their own IM model, a dispute-elimination process, single daily IM payments, and a proprietary segregation structure. The focus is on pre & post default processing which leads to operational and capital cost savings. It is delivered with the TMX Group and LSE’s UnaVista, with connectivity to Euroclear’s Collateral Highway. Banks tell us they see value in both the AcadiaSoft/Trioptima and NetOTC solutions, but it unclear so far as to how they will co-exist.
We are also seeing utility services emerging to support the legal negotiation and documentation challenges. Recommind’s “Perceptiv” solution provides ISDA CSA contract term scanning, and capture. Whilst Perceptiv has been used in at least one large tier 1 investment bank for a while, start-ups such as Logical Construct are also entering this space with newly designed software to handle a wide variety of document types. Legal service provider D2LT also offers OTC document generation, extraction and contract digitisation services.
Choose your running partners
Sell-side firms must decide quickly, if they haven’t already, which utility players they want to work with. But to meet the demands of different customers, who may themselves make different choices, sell-side firms must design a target operating model that allows for different paths through the forest.
Buy-side firms must also decide their target operating model, whose scope must include mandatory clearing in 2016, VM margining of non-cleared OTC in 2017, and IM margining for non cleared further downstream. Many buy-side firms will prefer to outsource to a partner who can help with all three challenges, as well as provide solutions for collateral transformation and optimisation. Not easy when some sell-side firms are pulling back even now from offering customer clearing services.
Utilities are becoming increasingly attractive, offering common standards, common process and uniform connectivity. If the major regulatory risk is dispute reconciliation, using a common platform surely reduces that risk significantly. Utilities do the heavy lifting for you and offer inherent efficiencies. A utility provider will maintain regulatory requirements and messaging and reduces the possibility of public dispute. Agreements will also be standardised, and drive adoption of best practice. Most utilities will connect seamlessly with vendor collateral and OTC solutions such as Omgeo, Lombard or Calypso.
Buy the right trainers and “carb up” for the race ahead
Whilst stretching this metaphor to breaking point, there is a valid concept lurking here. Infrastructure providers are soon to start testing. Firms must ask themselves how much they want to outsource. How will you evidence accountability and control if you can’t get standardised reporting across an outsourced ecosystem? Will you be an outlier if you keep the majority of collateral management in-house? Or will it become more difficult to trade without an industry approved solution? Is there any opportunity to position your books for roll-off risk, setting up smart collateral trades further down the line?
Buy-side firms must work out how to integrate cost-effective infrastructure across multiple funds with different OTCs in their portfolios, margined with collateral held at different custodians.
Sell-side firms must consider how to integrate across multiple silos such as equity, fixed income, prime brokerage, stock borrow/ lend & repo, whilst integrating collateral optimisation and transformation services.
In this challenging times it’s essential to set out with the finish line in mind.
You need to run your own race, looking into utility and on premise solutions to define what you want your operating model to look like when you finish. Then you can start defining your journey to 2020. The hurdles you face will vary in height and are gratifyingly small to begin with, but treating this challenge as a 5 year marathon made up of a set of sprints has merit.
Tip #1: start with the end in mind
We believe the best place to start is by defining your vision, objectives & goals. Be clear on your drivers – is it lowest operational cost or breadth of customer service? Identify specific long term objectives. Define the metrics by which you can measure progress. These are simple ideas, but many firms start with the immediate tactical imperative not the strategic end state in mind. At TFE we have developed simple techniques for clarifying the end goals quickly and simply.
Tip #2: design the operating model
Our philosophy is that target operating model defines how business process aligns with people and technology. Our top tip is to start by defining the business process end-to-end including interaction with external partners, initially at high level, then drilling down. Your key processes might include margin call processing; pre-loading triparty accounts; risk sensitivity matching etc. At the bottom level, define automation, controls and technology services, then abstract to create technology requirements, operational roles and responsibilities. Test the operating model against your vision: will it deliver your goals? TFE has developed tools to model this multi-dimensional picture so you can view it from any angle to decide quickly whether it’s right for your business, to ensure high confidence in your specifications and business case.
Tip #3: define your map
Only when you know where you are going can you decide how to get there! It’s very easy to get bogged down in detailed project plans and lose sight of the big picture. This is a marathon not a sprint. Our tip is to work out the “big rocks” that have to be shifted – that is, the large units of change needed to get you from your current world to your target state. Our tip is to build a simple roadmap model so you can test different implementation approaches until you find the right mix of cost, benefit and resource utilisation. By now it won’t surprise you to know that TFE has developed roadmapping tools to accelerate the road-mapping process.
This is one of the most interesting times to be involved in clearing and collateral management. We recognise some firms must sprint to adopt tactical solutions to meet minimum compliance standards. The smart firms will be those that design and plan thoughtfully, to emerge as victors in the marathon.
Jan 12th 2016: TriOptima announce TriOptima Margin, showing how they will provide a platform for bilateral margin implementation, click over to their website for more details, and see the PDF attached below.
This article was first published in edition 5 of Rocket, our magazine. Download available Rocket editions here, and save your up to date address in your profile to to indicate your interest in receiving a printed copy of the magazine. Copies are also available to purchase and subscribe to via the shop.
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