On March 1st, heightened requirements for the posting of variation margin (VM) on non-cleared derivatives trades will go into effect. The work being done in advance of the deadline is what some have called “the largest contract repapering effort in the history of the world”. Find out why the OTC market isn't prepared, what you can do about your own challenges and join our webinar where you can "ask anything".

On March 1st, heightened requirements for the posting of variation margin (VM) (Uncleared Margin Reform) on non-cleared derivatives trades will go into effect. The work being done in advance of the deadline is what some have called “the largest contract repapering effort in the history of the world”: the remediation of tens of thousands of Credit Support Annexes (CSAs) to comply with the new requirements. And the stakes couldn’t be higher – if remediation is not complete, market participants will be prohibited from trading affected products.  

The industry is sprinting to remediate as many agreements as possible before March 1st, but a perfect storm of factors has made this nearly impossible. Most banks estimate remediation efforts will be 40-60% complete by the deadline. From our position working in the trenches with two dozen buy- and sell-side firms, and talking with many more market participants, we found that because of very low early engagement levels from trading counterparties, most banks had, as of early February, remediated fewer than 5% of relevant relationships, and had negotiations in flight with barely more than 50%. 

What caused this situation? And more importantly, what can participants do to materially improve the outcome on March 1st and in the weeks that follow?

How did we get here?

A number of root causes, some of them typical of large-scale repapering efforts, others specific to Uncleared Margin Reform (UMR), created a complex, two-part challenge for the industry. 

One issue was the insufficient “industrialization” of contracting operations in most financial institutions. UMR necessitates engagement from many internal stakeholders whose input is required for each of hundreds or thousands counterparty negotiations. To avoid unnecessary back and forth, institutions need to do three things. First, effectively prioritize counterparties to ensure limited resources are aligned with highest-value relationships. Second, get internal stakeholders to codify, before beginning large-scale negotiations, the terms they would be willing to accept for each prioritized set of counterparties. Finally, implement a negotiation approach in which large numbers of negotiators follow a reliable process that makes effective, scalable use of this codification (for instance, via robust negotiation playbooks).

For a variety of reasons (delayed final regulatory guidance, distractions from other compliance requirements), many participants were unable to sufficiently formalize negotiation approaches before beginning counterparty outreach. With bilateral negotiations now expected to account for 70-90% of remediations, this failure to “industrialize” such negotiations is resulting in dramatically increased costs and causing material delays. 

The other major challenge, and the reason bilateral volumes are unexpectedly high, is that while many market participants assumed 60% of remediation volumes or more would happen through the ISDA Variation Margin Protocol, the reality is likely to be closer to 15-25%. 

The reason for this low uptake is that despite being an incredibly sophisticated tool, the Protocol offers neither sufficient substantive flexibility to accommodate the disparate requirements of different participants, nor sufficient standardization to drive meaningful operational efficiency in remediations. In trying to do both, the Protocol succeeds in neither. What could have been a valuable tool for addressing remediation requirements ultimately end up being a distraction that not only contributed to delays in getting negotiations underway, but also yielded a lower level of preparedness for bilateral negotiations than would have been the case had that been participants’ focus from the start.

The industry is struggling with the VM repapering challenge because it failed to meaningfully industrialize its approach to CSA negotiations. So how can market participants now regain lost ground?

The path forward

Too little time remains before March 1st to fully ‘industrialize’ VM negotiations. However, industry participants can take pragmatic steps to materially improve remediation prospects both ahead of the deadline and for the critical weeks that follow:

• Make greater use of existing ‘industrializing’ capabilities. Firms can drive significantly greater scalability in negotiations by making broader and more consistent use of the capabilities they have already developed for UMR. For instance, they can increase the number of negotiations that start with standard language, limit the scope of provisions for which bespoke escalations are permitted, or restrict which counterparties are allowed to negotiate terms beyond the scope of pre-approved language. Combined with a re-prioritization of counterparty relationships, this can lead not only to more remediations being completed by March 1st, but also to outcomes that are better aligned with business requirements.
• Adjust negotiation approaches. Because the likelihood of not being able to trade after March 1st is now much greater, and therefore the accompanying cost more probable, deal calculus in the next few weeks will be very different from what it was when negotiation approaches (templates, playbooks, approval levels) were developed weeks or months ago. Parties’ willingness to negotiate certain provisions or accept less-favorable terms should be adjusted accordingly.
• Communicate openly with counterparties. The industry as a whole is increasingly aware that, despite participants’ best efforts, not all contractual relationships will be remediated by the deadline. Being transparent about the tradeoffs involved in acceding to certain negotiation requests, in particular those exceeding the scope of pre-approved positions, can help focus attention on the terms that really matter.
• Accelerate “close to the goal line” negotiations. Implementing ‘super priority lanes’ and ‘fast closeout’ processes for negotiations where limited differences exist between the parties has two key benefits: First, a productivity boost, since the effort required in administering open negotiations is significant. Second, it increases the chance that downstream systems (especially for collateral management and trading) will be populated in time to permit trading on March 1st (a significant concern given the massive volume expected in the second half of February).

There are many critical lessons to be learned for future large-scale remediations. Whether it is General Data Protection Regulation, Brexit, Third-Party Risk Management, or even the later phases of margin reform, financial institutions would reap massive benefits over the coming years from adopting more ‘industrialized’ methodologies for large-scale contract remediations. The next few weeks will leave many in the industry bruised and battered. But if the right lessons are drawn, this painful period can also leave behind a game-changing blueprint for massively greater efficiency and predictability in addressing future regulatory challenges.
 

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