Uncleared Margin Rules: The Global Hurdles
This September marked seven years since the symbolic gathering of world leaders at the G20 summit in Pittsburgh that would radically change the face of derivatives trading. As markets continued to reel from the Lehman Brothers collapse a year earlier, they outlined an edict that all standardised (where appropriate) over the counter (OTC) derivatives would be “cleared through central counterparties by end-2012 at the latest.” It also established that non-centrally cleared contracts should be subject to (…) mitigate(d) systemic risk”. In other words establish risk management processes when OTC products are not centrally cleared.
This September marked seven years since the symbolic gathering of world leaders at the G20 summit in Pittsburgh that would radically change the face of derivatives trading. As markets continued to reel from the Lehman Brothers collapse a year earlier, they outlined an edict that all standardised (where appropriate) over the counter (OTC) derivatives would be “cleared through central counterparties by end-2012 at the latest.” It also established that non-centrally cleared contracts should be subject to (…) mitigate(d) systemic risk”. In other words establish risk management processes when OTC products are not centrally cleared and leads to the March 1st margin deadline.
With hindsight, it is obvious that two and a half years would be nowhere near enough time for the world’s financial institutions to accommodate the seismic shifts needed to move to a globally cleared regime. Only now, in 2017, is the industry approaching the light at the end of the tunnel.
In their approach, regulators have sought to find the global answer needed to a systemic worldwide problem. Interconnectedness between different markets and regions meant that new clearing regulation had to be coordinated to be effective and prevent arbitrage between different jurisdictions.
While this global mindset may be critical to success, its execution is not always straightforward. In June 2016, the European Union (EU) announced that financial institutions in the jurisdiction would not be able to implement new uncleared margin rules (UMR) in line with the September 1 deadline which US banks were on track to meet. The delay also put the bloc out of step with the Japanese market, which was ready to comply.
US regulators chose to push ahead with their deadline, to the alarm of some market participants who were concerned about the risk of pricing dislocation between the two regions – both the American Bankers Association and Securities in Financial Markets Association publicly expressed their opposition to the disparity in timelines. This is illustrative about the attitude of regulators towards non-cleared instruments, which evidently outweighed concerns about market imbalances.
The EU has committed to a revised timetable which should mean that all firms impacted will achieve implementation on a phased basis by March 2017, so in reality this amounts to only a six month period of disruption. Equally, because daily margining is already part of modus operandi of most CSA, the impact on pricing has been minimal so far. The firms affected are typically larger, global institutions which have both a European and US desk and so are ready to start operating under the new rules on posting initial and variation margin (IM and VM). General opinion among traders at the moment is that if they can trade with a European bank they will, but if they cannot find the right price, they will still consider the US.
These glitches are to be expected when implementing a new margining regime of such ambitious size and scale, but they cannot always be so easily resolved. One enduring concern is the unintended impact of UMR on operations in different regions, such as the “Time Zone Tax” issue which has been highlighted by industry media and the International Swaps and Derivatives Association. US (and most likely forthcoming European) rules dictate that margin must be settled the day after trade execution (T + 1). This is not a major issue when both counterparties are in the same time zone – or indeed even when trades take place between Europe and the US. However, as the Asia-Pacific region is 14 hours ahead of the US, T + 1 has effectively ended for them before trading has even started in the US on the same day. The answer is for trading parties to pre-fund the collateral exchange instead, by using the services of a custodian or a prime broker which ensures the VM of the trade is covered. However, this service is not free so it effectively creates an additional ‘tax’ for companies operating further away from the US.
Anecdotally, some traders in Asia-Pacific are already showing a preference for trading with European counterparties to avoid the additional cost. Come March 2017, when T + 1 is imposed on cross-border trades, there is a possibility that some regions will make efforts to further develop their own markets. This risks further reducing overall liquidity, which runs counter to global regulatory objectives. It is too early to speculate on a potential solution, but it is possible authorities will want to at least consider options which will further their goal of global harmonization and prevent siloed markets developing.
Beyond these esoteric issues, one of the greatest challenges banks have faced is achieving the radical structural change needed to comply with the new rules. Principally, this has driven the wholesale industrialisation of a process that historically has been distinctly arts and crafts. Up until recently, the margin processes in OTC derivatives were based on emails, phone-calls and back of the envelope calculations, which were typically the norm in the management of disputes between large players. This has changed beyond all recognition so banks can scale up their treatment of derivatives transactions to remain competitive as well as comply with new rules.
The extent of market infrastructure development that has taken place in recent years for the industry to cope with the changed environment, even outside of central clearing, has been remarkable. The creation of the Blazer platform by the main players and providers, for example, was designed to enable participants in the uncleared space to agree on standardized models to calculate IM. Its direct link to the margin transit utility has allowed for straight-through processing (STP) of agreed margins, standardization and STP being both prerequisites of industrialisation. Inevitably, there will continue to be OTC, bilaterally traded products which clients need and which need hedging, so the industrialised response is one of the few options to help these trades remain feasible (not to mention save on costs). Banks are having to coordinate and adapt in order to remain competitive. Given that approximately 80% of business is traded between the major players, there is a huge opportunity for efficiency if common models and practices can be agreed between this group of around 20/25 players.
Simultaneously, this centralisation trend is gaining momentum within individual institutions. A centralised platform which can break silos across asset classes is becoming an essential tool at a time when more or less every trade on every asset is collateralized and it can optimise funding throughout the business. Addressing the fragmentation of collateral management is a challenging task but has a demonstrable impact on the bottom line at a time when inefficiency is a luxury no one can afford. Conducting business is becoming more costly and complex due to the tidal wave of new regulations making stipulations on bank capital which have accompanied new collateral rules. At a time when a growing number of (negative yielding) high quality liquid assets (HQLA) are needed to comply with prudential regulation, it has become increasingly punitive for banks to hold inventory of this kind. This in turn impinges on liquidity – the fixed income ‘credit market’ in particular has suffered from reduced liquidity given the cost associated with holding corporate bonds on a balance sheet.
The banking world may be four years behind the original G20 deadline for clearing and risk management processes regulations, but the transformation it has undergone arguably surpasses the scope and standards that could have been envisaged in 2009. Ambitious industry-wide initiatives such as Target 2 Securities are evidence of how far market infrastructure has evolved in an interconnected world. Nonetheless, the efforts of both regulators and the industry in achieving the harmonised global approach needed to succeed undoubtedly face further challenges.
This article was first published in edition 8 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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