Are you ready for uncleared derivatives margining?
In order to buttress financial markets against another 2008 crisis, mandatory margin rules are being introduced across the globe.
The risk mitigating effects of central clearing are being replicated by regulators with new rules extending to encompass all non-clearable OTC derivatives trades. Many vanilla products are now eligible to clear with a high proportion of them now voluntarily cleared in advance of the regulatory mandates.
The forthcoming rules for non-clearable swaps originate from a BCBS-IOSCO paper setting out a framework, which is currently being drafted into national regulations, the status of which is this:
We can expect to see divergence in the rules, but hopefully not in a way that produces incompatibility between each set. The current draft rules in the EU align to those of the CFTC in many ways but use the Euro rather than the Dollar for inclusion thresholds - such as €8bn versus $8bn - leading to difference due to exchange rates.
From September 2016 onwards, the largest firms will be obliged to exchange initial and variation margin (IM & VM) for all new trades. From March 2017, ALL firms with un-cleared OTC portfolios must exchange VM daily – quite new for many users of OTC products. The need to exchange IM is made mandatory in annual stages with a threshold of notional decreasing over time until September 2020.
Key departments impacted by these rules include Legal, Operations, Technology, Risk Management, Compliance and Trading. Figure 1 is a guide to be ready for September 2016 and March 2017.
The new rules apply only to trades executed from September 1st 2016, in which case the ISDA documentation framework needs amending to cater for the pre-September portfolio and post-September portfolios separately.
Even though the legal setup is complex, the operational requirements are also challenging. One outstanding issue with the US regulations already adopted - and possibly also the forthcoming EU regulations - is the need to deliver assets to cover IM on Trade Date + 1 business day.
ISDA have published a paper which discusses the challenges in detail on this page (https://www2.isda.org/functional-areas/ wgmr-implementation/). Figure 2 illustrates a typical global trading day with the resulting portfolio margin calculations and settlement cycle. It is clear that between the US and Asia, meeting the regulations for settlement could potentially dictate which assets are pledged (JGBs for example follow a 3 day settlement cycle per market convention). Where both parties use a common tri-party agent, this could speed up the book entry transfer of assets (Clearstream operating and enabling the settlement of collateral for 23 hours out of 24).
The regulations have a high level of detail regarding:
- The approach to calculating IM and your choice of model
- How your chosen model should be calibrated and back-tested
- How your choice of model must be independently governed and approved
- The configuration of scenarios into the model
- The split of asset classes and related scenarios
The drivers for change will come from departments such as Operations and Collateral Management. These teams may be considering third party services in addition to internal change to meet the regulations. See Table 4 for some of these changes.
Trading and Resource Management
Once these regulations become effective, there is a direct economic effect of delivering and receiving assets under the new margin agreements. Although for large banks the economic effects of margin are well embedded in their pricing, this may be new for many firms when VM takes effect in March 2017. See Table 5.
Clearstream’s triparty platform, the Global Liquidity Hub, provides ways to make the implementation of the regulations easier and quicker, here are the highlights. See Table 6 and Figure 3.
For a Party to integrate the Clearstream Triparty service legally, they would firstly establish their bilateral relationship with their counterparty, then secondly enter into an agreement with Clearstream to provide services. Each party only has to execute an agreement once with Clearstream to then move collateral with any number of other parties. For each bilateral relationship Clearstream would need an eligibility criteria agreement which for the bilateral margin regulations may well be similar, but allows customisation to suit each party.
The preparations for September 2016 and March 2017 cannot be left much longer. If your firm is new to operating margin agreements, now is the time to allocate resources to understand the impacts and plan your implementation.
With the Global Liquidity Hub, Clearstream provides an efficient platform to meet the new regulations, and integrates with the various market infrastructure projects which are underway. See Figure 4.
This article was first published in a special edition of Rocket, our magazine, which was available to attendees at The OTC Space and The Field Effect breakfast briefing, held on the 7th of April 2016. This special edition is now only available as a PDF, which can be purchased through The OTC Space Shop. The live event is also available to watch via The OTC Space YouTube channel.
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