A regulatory bottleneck?

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A new regulatory timetable is starting to emerge due to Coronavirus (COVID-19). The recent announcements of a delayed commencement to SFTR (Securities Financing Transactions Regulation) could cause a bottleneck for firms due to timelines clashing with the CSDR (Central Securities Depositories Regulations) and Uncleared Margin Rules (UMR) over the next two years. 

Let’s look into UMR, which is the most complex and requires significant resource and financial capacity to comply with the rules. In July 2019, the Basel Committee on Banking Supervision (BCBS) and the International Organization of Securities Commissions (IOSCO) proposed guidance for a one-year extension of the final implementation phase of the uncleared margin rules (UMR). Global regulators have agreed with this guidance and have started to change their regulatory technical standards. On December 5 2019, the European Supervisory Authorities (ESAs) published their final report and public statement on bilateral margin amendments and an introduction of fallbacks in over-the-counter (OTC) derivatives contracts. The revised margin regulatory technical standard addressed the following topics: 

  • Variation margin 
  • IM phase-in 
  • Intra-group derogation 
  • Equity options derogation 
  • Amendments to legacy contracts 

How will the extension of the compliance date affect preparations? 

As the AANA (Average Aggregate Notional Amount) compliance threshold reduces and more buy-side firms are caught, critical preparatory steps are required. These include documentation, custody account setup, margin calculation and the backtesting of IM models. 

The challenge for the last phases of UMR has always been the volume of in-scope firms impacted. Phases five (September 1 2020) and six (September 1 2021) according to the ISDA analysis, could mean 1100 new firms are having to comply with the regulation over the next two years.  

As a new process combined with the complexity of the requirements, this will create a potential bottleneck on internal and external resources, especially in legal, custody, operations and risk.  

What are the critical challenges of UMR? 

As well as the squeeze on documentation and custodian relationships, the new IM model requires model development, implementation and governance, supported by the ongoing monitoring and performance measurement of the model.  

The EU regulator has been definitive on all IM model users being able to validate their calculations, meaning that you will need to continually upgrade, maintain and ensure proper controls around validation, backtesting and benchmarking. 

One potential challenge that is not yet clear is the upcoming European Market Infrastructure Regulation (EMIR) refit where we wait for the technical standards in Europe and what external IM model validation may be required.  

What impact will UMR have on trading strategies? 

The sell-side is working towards margin valuation adjustment (MVA). Where they are adversely impacted, you can expect the cost of funding to be passed back via pricing; there are potential solutions to mitigate this. Firstly, for derivatives users wanting to explore pre-trade analytics options, it could be cheaper to hedge using a cleared derivative or an exchange-traded instrument. The business may not be 100% hedged, but this could be an acceptable risk versus the cost.  

Certain product exemptions depend under which regulatory regimes you and your counterpart trade. In Europe, for example, the exemption on equity single stock options has been extended until January 4, 2021. Additionally, you may want to consider the cost of a trade before execution; therefore, pre-trade analytics should be something to consider. 

There is also the issue of collateral drag. IM exposure needs to be covered by eligible collateral assets, and these will be locked up in a segregated account and not available for re-hypothecation, meaning collateral costs will go up. Will organisations choose to allocate those costs back to the trading desk or centralise them as a cost of business? 

What Tactics Are Firms Using to Reduce IM Exposure? 

Beyond the clearing, firms will look at portfolio compression or novations to reduce their risk profile and manage their AANA by reducing the notional outstanding of derivatives. Another option could be exchange-traded derivatives (ETD) or ceasing to trade in specific products altogether.  

There are also tactical ways to manage collateral posting, for example, splitting the group $/€50 million IM thresholds purposefully, rather than randomly.  

How will UMR affect bilateral relationships and Prime Brokers? 

Clients might find their liquidity providers have a prioritisation list (are they on it?); equally, they might want to consider reducing the number of trading liquidity providers to make compliance more manageable.  

Prime brokers already have a critical role in a functioning market, and UMR does not change that. 

The collateral upgrade trade will likely become more prevalent alongside front-to-back solutions for calculation, documentation, settlement, dispute management and ongoing monitoring. Naturally, all of this will come at a cost. 

What pressures does UMR place on resource and technology? 

There are several pain points created because of the margin rules. New resources and technology are required to implement and process new legal documentation, custodian connectivity, risk models, collateral management workflows and treasury management. Firms will need to utilise technology providers to support those issues, create and implement a plan, quantify and manage the delivery risk that exists.   

Timeframes are shrinking. Due to the large volume of clients, custodians are setting deadlines for guaranteed onboarding. Significant planning and testing are required for legal data, IM exchange, SIMM (Standard Initial Margin Model) calculations and margin processing.  

Ensuring your business-as-usual (BAU) playbooks are complete, and responsibilities are clear before go-live are imperative, you do not want any significant surprises. 

For more information, get in touch at chetan@marginreform.com

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