Big banks are, ironically, ‘building’ small. Faced with an unprecedented compliance requirement in the form of new margin mandates, banks are doing what they have always done: tackling each regulation anew by constructing small compliance ‘houses’. 

By Mathew Keshav Lewis and Barry Quinn, Co-heads of Global Banking Practice, Axiom

May 2016

Big banks are, ironically, ‘building’ small. Faced with an unprecedented compliance requirement in the form of new margin mandates, banks are doing what they have always done: tackling each regulation anew by constructing small compliance ‘houses’. Rather than identifying solutions that will allow them to meet massive compliance requirements more effectively, the house-build approach tackles each regulation separately, with the same inefficient toolset (more regulation equals more lawyers).

An alternative solution is to build compliance skyscrapers: leveraging fewer lawyers, but more technology and robust process to enable compliance solutions that solve for scale and repeatability. 

Uncleared Derivatives: A Brief Primer

For years now, banks have attempted to keep-pace with the steady stream of complex regulations developed in the wake of 2008: Dodd-Frank, EMIR, FATCA, the list of acronyms goes on.  Whatever your perspective on the regulations, and whether they will actually strip risk from the financial system, they’ve been a huge operational challenge for banks. With two deadlines both looming and evolving, there is universal concern about the industry’s ability to handle the volume of negotiation work that will be required. (So much so that European Commission just last week delayed the first – September 1  – deadline. In so doing, the Commission broke with U.S. authorities who have retained the September date and have further clouded the issue of compliance with disparate deadlines.)

For readers not in the weeds on the broader issue, a brief summary: New regulations have introduced margin rules, which demand counterparties calculate and exchange two different types of margin when holding non-cleared OTC derivatives contracts. September 2016 was the original deadline (and remains the hard US date) by which the largest banks will need to exchange initial margin (IM) on new non-cleared OTC trades. IM is a portfolio based measure of risk, which regulators offer two methods to calculate, either using a Value at Risk approach, or a simple schedule with percent of notional. 

The second, and in many ways more concerning deadline (because it applies to all bank trading relationships) is March, 2017 – the date by which variation margin (VM) becomes mandatory. VM is margin that fluctuates from day to day based on the net exposure between two counterparties. 

In the run-up, rafts of new agreements (CSAs) need to be negotiated, and the repapering will be anything but straightforward. Yes, ISDA Protocols will address a portion of client agreements but current estimates suggest almost half will require bespoke calculations and negotiations.

And, while the first deadline is seemingly limited to the top 20-30 banks, each has dozens of separate legal entities scattered around the world. It’s not hard to see how 20 counterparty agreements quickly balloon into hundreds, if not thousands of agreements.

Together IM, and VM will have far-reaching impact on banks.  Most critically, if banks fail to meet these margin deadlines, they won’t be allowed to trade derivatives.  (It deserves to be repeated for emphasis: trading ceases).  Second, the scale of the effort to comply is so massive that it has no comparable precedent. 

Same Small Houses

The headline diagnosis for the malady that is the margin deadlines tracks to the concept of scalability: building a solution such that the bigger the problem gets, the more efficient and effective that solution becomes.

Building for scale is a task that has been antithetical to banks’ historical approach to legal and compliance.  Banks typically start with the premise that CSAs should be negotiated by artisans: highly credentialed lawyers.

When the volume of contract negotiation or renegotiation grows, more lawyers are engaged. The result is thousands of expensive lawyers, negotiating a multitude of CSAs using disparate technology platforms and lacking adherence to policy, consistent terms and effectiveness.

The result is a predictable mess:  Banks would be hard-pressed to tell you how many uncleared derivatives contracts were amended last year and whether they adhered to internal standards, let alone how many they need to negotiate or renegotiate in the wake of margin mandates.  They certainly won’t be able to tell you how many CSAs contain specific clauses that need to be modified or thrown out altogether.

And let’s not overlook the most important “won’t”: With the massive repapering effort required by margin mandates, banks won’t be able to use the same old “construction” solutions, without solving for scale. No amount of additional lawyers, no matter how competent, can turn a competency for building homes into one for constructing skyscrapers, overnight (or at all).

Building Big: Skyscrapers

A margin mandate problem doesn’t call for an artisanal solution, it calls for an industrialised approach: a combination of technology, processes and the right mix of talent, such as skilled negotiators with domain expertise, and lawyers to anticipate important risks and provide high-value advice. Such a machine runs on the standardised application of process, tools and technology.

This approach embraces ‘scale.’ Instead of individual lawyers renegotiating CSAs ad-hoc, banks need to adopt a repeatable, operationalised negotiation model, working with both process-led providers and external counsel (fig. 1). 

This model follows a 7-step approach toward executing the compliance process:

1. Define and capture: Client knowledge, interpretations and opinions are captured up-front so that they can be consistently applied via repeatable processes and playbooks to deliver repeatable, accurate high-volume work;
2. Advise and Codify: A small pool of strategic lawyers and external counsel advise on commercial approach and overall risk mitigation/tolerance;
3. Operationalise: Axiom develop negotiation playbooks, workflows, templates, scripts and fallback positions;
4. Draft and Negotiate: Proprietary technology solution, IRIS BY AXIOM, automates legal drafting and optimized pyramid of negotiators and project managers execute against playbooks, escalating efficiently when needed;
5. Audit/Confirm: Axiom ensures playbooks have been adhered to, while small pool of strategic lawyers provide bespoke opinions for non-standard relationships;
6. Capture: IRIS captures CSA contract data and key terms in central, searchable, fully auditable repository for future compliance;
7. Execute: A complaint contract is executed.

At the risk of overextending the analogy, the technology “capture” stage is the compliance skyscraper’s foundation – a foundation on which banks can build in higher and higher increments, if needed.  And needed it will be: margin mandates are only one among a number of regulations that will require the application of data to contracts and benefit from the cumulative accumulation of a powerful information store.

This data will not only unburden banks’ compliance with future regulations (additional stories), it also promises to offer real-time visibility beyond compliance in the form of business intelligence, decision support, regulatory capital planning and risk-weighted asset modeling.

Big Risk, Small Solutions

We don’t underestimate the scale or complexity of the margin regulatory mandate that the big banks face. Quite, the contrary.  Our point is that the solution to the knot has been to add more string (more regulations = more lawyers). Instead, margin mandates require a re-orientation of status quo efforts. Houses don’t solve for scale; skyscrapers do.

For more information visit www.unclearedderivatives.com