The new Variation Margin regulations impact all financial entities as well as systemically important non-financial entities that deal in uncleared OTC trades. This means that from March onwards, all new trades will need to be captured under a collateral agreement and margined daily with collateral posted to cover the MTM movements. Whilst this may sound simple in principle to achieve, entering into a collateral agreement is no simple task.

The new Variation Margin regulations impact all financial entities as well as systemically important non-financial entities that deal in uncleared OTC trades. This means that from March onwards, all new trades will need to be captured under a collateral agreement and margined daily with collateral posted to cover the MTM movements. Whilst this may sound simple in principle to achieve, entering into a collateral agreement is no simple task.

With the implementation date of 1st March looming ever closer, it would appear that banks and clients still have some way to go to be ready in time. SIFMA AMG recently wrote to regulators to advise that only 8% of the regulatory-compliant CSAs needed had been executed by their members so far and hence they have asked for a six month transition period to be put in place. This would allow trading to continue with existing broker / dealer relationships post 1st March rather than see clients blocked from trading the OTC market. Given the volume of agreements still needed to be put in place, there is a genuine fear that liquidity could dry up completely in some markets.

On top of this, banks are not focused on resolving the issues that smaller firms must overcome to get ready. Most banks are offering a halfway house solution by providing infrastructure or valuation services (at a cost) but is anyone providing a one stop shop end to end solution?

Buy Side Barriers to Overcome

• Volume of Agreement Negotiations
• Client Portfolio Analytics
• Risk Manager Approvals
• Back-stop Collateral Buffers
• Collateral Optimisation
• New Policy/Governance
• Infrastructure Implementation
• Settlement Issues
• Cost Benefit Case
• Resourcing

Banks themselves are not immune from the issues with the sheer volume of agreements and legal negotiations creating increasing pressures on their legal teams. Bringing in external consultants and contractors can only go so much in the remaining time frames and this is forcing banks into a situation of prioritising their client relationships. Even going as far as to suggest that they will have to stop trading with some clients as the date edges ever nearer.

It was estimated that circa 150,000+ of existing collateral agreements would need to be renegotiated by the time the dust settles on the new rules and that is before the impact of new clients is taken into consideration. On top of this, there are a number of clients that are exempt from the rules that wish to volunteer to collateralise. This would allow them to improve pricing and gain access to longer tenors, but they find themselves crowded out in the prioritization process as well as needing to find the expertise to take on such a process.

On top of this, the regulations themselves are still not finalised in all jurisdictions, with differing approaches being applied on various aspects such as implementation dates, product coverage and how to manage trades with entities captured in non-netting jurisdictions. Asian countries such as Australia, Hong Kong and Singapore for example, propose an exemption for countries that cannot obtain enforceability opinions whereas the European rules have suggested a 2.5% portfolio cap. How this works in practice is left open for interpretation with local law claw back always a risk for banks and clients operating in these jurisdictions.

Buy Side denial or good gamesmanship?

There is a part of the buy-side community that has taken the view that as they themselves are not regulated by the various bodies imposing the new rules (can you explain?) that they are therefore not captured under the rules. Whilst this may be technically correct, they are impacted at the point they trade with a bank or entity that is regulated and hence this will dramatically cut down the list of eligible trading partners they have post March. It is true that they can trade away for a period, but this may require setting up new trading lines within their risk departments who I am sure will only have a limited appetite for credit to unsecured trading entities out of Asian countries.

There is also a significant cost impact to the buy-side if they continue to trade uncollateralised. Whereas historically you could always find a dealer that would be willing to undertake a trade for relationship pricing purposes, it is now almost impossible to find a bank that will discount a price after taking into consideration the cost of their own market risk hedge (banks can no longer warehouse risk), the funding cost for collateral they will need to post on their market risk hedge, the cost of capital for storing a long dated uncollateralised trade on their balance sheet to maturity as well as the P&L reserve they must take (CVA charge) for managing the counterparty risk to term.

When all of this is priced in, clients will see a 300-400 basis point increase in execution costs or a restriction on tenors and products that banks are willing to trade uncollateralised in order to optimise their balance sheets. It is also worth considering that the increase in executions costs needs to be weighed up against the increased support costs that a client moving to collateralising trades for the first time will incur.

Whilst the traders will benefit from access to a wider range of exotic products as well as longer tenors and better pricing and hence may be pushing their firms to go down the collateralising route, the risk management departments will be picking up new default and market risks to manage as well as having to find and fund eligible collateral in a form acceptable to the banks and all this can only happen after they have negotiated agreements and brought in expertise and infrastructure through which to manage the process.

Some clients feel that these costs are already being built into their increased trade pricing so are looking for banks to supply solutions to all their issues or pick up / share some of the costs for the pleasure of their future business.

Build or Buy?

As collateral management in the OTC market has historically been associated with bank to bank or bank to high risk/high volume trading relationships, the infrastructure has been built in-house and geared towards solving the banks needs rather than tailored to external client requirements. It has also tended to require a client install and several months of consulting in order to set up the systems and get them ready for go live.

That is all changing with nimble cloud based technology (CloudMargin, Lombard Risk Agile, TriOptima's triResolve Margin, etc.) delivering quick to market solutions, which opens the market to outsourcing opportunities.

Some banks are offering to pay for infrastructure and simplified connectivity as a means to enticing their clients into being regulatory compliant for their own needs. Others are proposing an OTC client clear model as an add on to existing clearing relationships or as a means to expanding their client fees. These only solve a single dealer relationship problem for a client and if they have multiple trading relationships then they could find themselves facing off to various solutions and infrastructures and still having to pay towards each one (see Figure 1). On top of this they still need to set up the new policies, governance, controls, settlement accounts, intraday reporting as well as hiring in resources to take on these functions.  

Managing multiple margin calls will require a consolidated (treasury) function to take control of sourcing and funding the collateral. This also opens firms up to collateral realignment failures, asset transformation and eligibility issues for the first time, not to mention valuation disputes and additional portfolio reconciliation issues.

This will all require projects to be set up, experienced staff or consultancies to be hired, governance, policy and best practice processes to be implemented; all of which require significant time to establish as well as access to an investment budget. The easier option for some clients is simply to decide to exit using OTC products at present or to look at alternatives such as listed and clearing. Others are expecting their main banks, brokers and dealers to help them solve the problem by providing infrastructure or valuation services, but most are still unaware that independent collateral utilities exist that could help them fast track collateralised trading and minimise the internal disruption.

So how do buy side firms navigate compliance with the new rules?

Documentation

Firstly, they need to sign a collateral agreement that defines the legal basis under which margin is called and the collateral is held. This can be done through the ISDA Amend/lSDA Protocol system in partnership with IHS Markit. The protocol works by getting users to fill in a specific questionnaire in which they elect certain elements they want and then the system matches them. When there is a match between the questionnaires, it is uploaded by both parties; but when the questionnaires do not match, the parties need to amend and resend them. Unfortunately, not everything can be captured in the current questionnaires so you may end up in bilateral negotiations if you need to deviate from the standard i.e. the new CSA approach in the protocol doesn't allow for variation margin segregation, which a lot of 40 Act fund clients require.

Alternatively, AcadiaSoft is launching Agreement Manager which uses its own matching capabilities to create a single CSA record between two counterparties. This means that if the initial questionnaires don't match, users only need to amend the single record rather than resubmit an updated set of questionnaires. This allows you to agree the specifics of a new CSA and at the same time create a single data record that can serve as the source for any future changes to the document.

The lSDA Protocol and AcadiaSoft's Agreement Manager are not the only CSA tools available to firms. Law firm Allen & Overy, along with Deloitte launched MarginMatrix. The tool codifies the laws in various jurisdictions and automates the drafting of legal documents, which can be used in variation margin compliance for repapering credit support arrangements.

The last resort is always to deal directly with Banks whilst lobbying to get the attention of their legal team to allocate time to negotiate bilaterally with you. This may mean you are put in a queue as banks are forced to prioritise the repapering of their existing collateralised clients to get them complaint by 1st March as well as dealing with the high volume of new client requests.

All trades or New Trades?

One of the questions that clients will need to think about is whether to only start collateralising new trades going forward or whether to allow existing trades outstanding to be captured. There are pros and cons for each which depend on the products and volumes you have traded historically and or intend to trade going forward.

Positives are that you may be closing out an existing trade and hence may want old trades to be included for netting purposes in order to reduce margin requirements.

Banks will also get a capital benefit for moving a trade from uncollateralised to collateralised as the RWA allocation will move from an unsecured cost for remaining tenor to a secured cost for a ten/twenty day close out period. If a client has a number of long tenor trades outstanding, then the banks will be pushing for these to be captured under new CSA arrangements. If the savings are substantial then banks may be willing to offer incentives such as a supplying the collateral infrastructure, valuation services or running monthly analytical services that allow for the calculation of collateral buffers.

The negatives are that the more trades you include under an agreement, the greater the possibility for a reconciliation issue or valuation dispute. If the trades are typically all the same way i.e. do not net down, then this may potentially mean that you need to allocate larger collateral amounts to your collateral buffer to cover future margin call payments.

Rationalise Trading Relationships / Trading Optimisation

Typically, clients have three to five main trading relationships that they deal with to cover their range of trading products. If each of the relationships offers to provide a different solution, then the client could end up facing off to five different systems and processes.

From a cost perspective, having lots of trading relationships going forward will be inefficient as clients will want to optimize where they execute OTC trades to minimise collateral postings as well as the amount of portfolio analysis needed to estimate future MTM/collateral requirements. By minimising trading relationships, it allows clients to put in place ‘risk trading tools’ that run portfolio optimization techniques such as ‘what if scenarios’ to calculate which one will offer the cheapest execution costs, best eligible posting options (can be optimized for funding costs) or which portfolio offers best netting opportunities. In addition, clients should look to amend trading patterns to maximize compression and risk netting by using specific reset and final settlement dates.

Valuations/ Analytical Analysis

Whereas previously some smaller firms may have been relying on banks to provide regular valuations on OTC trades monthly, they will now find themselves in a situation where they need to obtain daily valuations on both trades and collateral as well as needing to run increased analytical models to ensure they can set aside collateral buffers to meet potential margin calls.

Risk/Treasury officers at buy-side firms will hold off from approving collateral agreements until they have understood the risks and can control the impact that these bring and this is one of the main issues still facing the market as many firms do not have the capability to run these models daily.

Signing a collateral agreement can in some ways be seen as similar to signing a blank cheque book as you suddenly find yourself in a daily ‘must deliver’ environment regardless of the amount of the margin call. Failure to deliver puts you in ‘default’ under the agreement and you risk having all trades closed out. For this reason, risk officers need to understand the potential mark-to-market value that the portfolio could explode out to, as well as needing a way to understand the impact that new trades will have on the portfolio. This means running some quantitative models such as monte carlo simulations in order to work out how much collateral could be required at short notice. Treasury will then need to create a backstop liquidity buffer that will allow them to source eligible collateral to this amount within the required settlement time frame, which is normally same day or next day. The most common techniques are to negotiate overdraft facilities that you can draw at short notice, use of repo facilities, use of transformation agents or to build up cash or collateral reserves.

The short-term solution to the valuation problem is to ask the banks to provide a feed of their own daily trade valuations directly in the collateral infrastructure being used. This means that a client’s ability to dispute valuations and margin calls is diminished until they can source valuations direct from their own trading or middle office systems. It also means that the funding cost of the collateral required is linked to the banks valuations until such time that a client can take control of this.

Some banks are offering out their risk systems for clients to use in order that the analytics aspect can be managed, whilst others prefer to look at more independent providers such as OpenGamma and Razor Risk to provide these reports. The main question with any of these solutions is who will provide the trade details and the market data that these systems need to calculate the reports as this increases the set-up time as well as the infrastructure complexity, not to mention who pays the data and service costs.

An alternative is to ask Banks to make their own credit simulation calculations available weekly/monthly to clients as well as putting in place a simplified new trade add on approach in between calculation dates to estimate potential collateral requirements.

Asset Transformation

Some banks are offering a multicurrency back-stop credit facility (collateralised through the posting of assets) which can speed up access to eligible assets that the treasury functions can draw down in the required currency to meet margin calls. This is similar to using a transformation agent such as Euroclear/Clearstream's Triparty services, which switch existing holdings into eligible assets that can be delivered under the collateral agreement, only that it guarantees you will always be able to find a willing provider of eligible collateral.

Innovation in this area of the market is still in its infancy with peer to peer repo platforms just starting to take off as well as more established ecommerce providers such as BGC Partners entering the market with liquidity solutions such as their ColleX multi-asset platform which promotes collateral mobility and the ability to address the new reporting requirements.

Collateral Optimisation

Once collateral has been posted across a number of agreements then daily optimisation techniques can be applied to a Treasury inventory in order to work out the most optimal use of assets to meet daily collateral requirements. GFT Financial and Razor Risk have already developed tailored trade and collateral workbenches for clients and if these are linked into messaging or settlement platforms then the whole optimisation process can be reduced to a click of a button.

Innovation

With so many moving parts involved in managing a margin call, this is an area where continued innovation of infrastructure will help to streamline the process. The market has changed dramatically over the last three years with the introduction of initial margin being the main catalyst and the move to cloud based solutions another.

With the trend towards outsourcing taking pace there are still areas ripe for market innovation, such as the emergence of an OTC trade data warehouse/data centre to speed up connectivity to vendors and increase data quality, as well as increased use of comparison tools for transparency/regulatory reporting, and the need for new data standards for amending haircuts/eligibility and concentrations electronically but to name a few.

In the short term, with the date fast approaching, I would suggest that buy side clients reach out to their relationship managers to understand what solutions are being offered by their banks and brokers to help them get compliant and whether they will be allowed to continue dealing in OTC trades with them post 1st March – regardless of whether they see themselves as exempt from the rules.

Alternatively look to partner with an outsource agent such as The Collateral Utility and let them take the pain away.

This article was first published in edition 9 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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