After warnings during the first quarter of the year that the implementation of global variation margin requirements would result in major disruptions across EU and US markets, experts have told FOW that most of the foreseen issues will be resolved by the deferred deadline for implementation in September.
On the eve of the variation margin implementation, it emerged that the financial industry was far from ready to comply with the regulation. Months of speculation on the disruptive effects of the regulation culminated in a letter from a group of trade bodies including the International Swaps and Derivatives Association and the Global Financial Markets Association to twenty global regulators. The letter was sent at the end of February and asked the regulator for leniency and global regulators complied with the requests at the end of February.
Experts have told FOW that the delay is likely to ease many of the concerns firms and lobby groups had before implementation in March.
“What we usually see with a regulatory delay is that people take their focus off the task at hand and focus on something else. I would say this is one of the rare occasions when an industry is using a regulatory delay as intended, partly because in order to qualify, both the US and European regulators specified that you need to show you’re taking steps to be compliant,“ said Lee McCormack, head of strategy and product development at technology provider CloudMargin.
The first regulator to issue a delay was the Commodity Futures Trading Commission (CFTC), which issued a no-action relief letter on February 14, giving the market an extension of six months to ensure their compliance. The CFTC stipulated that firms had to show progress on compliance in order to be able to take advantage of the delay.
Regulators in Hong Kong, Singapore and Australia said last year they would take a pragmatic approach to the introduction of the rules. The European financial authorities, however, took a more ambiguous stance. While the European Securities and Markets Authorities reprimanded firms for failing to get ready before the deadline, it did say it would defer the application of the variation margin rules to national regulators.
McCormack argued that the difference in tone between the US and EU responses could be cause for concern among European firms.
“We saw no discernible difference in behaviour between firms in the EU and the US. It could be that some EU firms were more worried about the deadline because they didn’t know how seriously to take the EU move to delay enforcement,” McCormack told FOW.
The delay also suppressed the projected spike in trading the market had expected in the run-up to the March 1 deadline.
“In March overall there wasn’t a huge notional impact on volume. Anecdotally we did see firms saying there was a lot of confusion, which is usually the case when there is not a lot of guidance. It will be quite interesting to see whether there are spikes in trading or depressed trading closer to the date,” said Colby Jenkins, analyst at research house the Tabb Group.
CloudMargin conducted an informal poll among 80 market participants, including buy-side, sell-side, central counterparties, consultants and other service providers located in the US and Europe to assess how these firms had reacted to the regulatory delay. The results of the poll show a sharp distinction between behaviour on the sell-side and that on the buy-side.
According to the data, all of the buy-side firms polled said they would be continue to work with their existing trading strategy, while 29% of tier one banks and half of tier two institutions said they would be making minor adjustments. Furthermore, 14% of buy-side firms said they had seen fewer counterparties and lower aggregate volumes since March 1, versus 11% among large sell-side institutions.
The challenges for implementation of the variation requirements are manifold. One that was cited often was the amount of work involved in re-papering agreements for firms that had many counterparties. Trade bodies and financial firms alike argued that, because of the scale of the regulatory changes and the complexity of implementation, firms would be forced to prioritise re-negotiating relationships with their most actively trading derivatives clients.
“I hope six months will be enough to get the re-papering done, this is the most time-consuming aspect of the regulation,” Jenkins told FOW. He added that he expected the compliance to be gradual. “Firms will be testing the waters, get the documentation ready and work out kinks so there are no surprises come September.”
According to the CloudMargin poll, buy-side firms expected to have all credit support annexes needed to exchange variation margin to be ready before the end of July, while a third of large sell-side institutions said they expected to need time until the first of September. Another third of tier two banks also said they would need until September. Perhaps surprisingly, smaller sell side firms were also the only types of firms to say that they had met the deadline, with 17% of respondents.
Another challenge for the market was operational, as exchanging variation margin on an intra-day basis is no small feat. A report by consultancy giant Pricewaterhouse Cooper suggested the new margining regulations bring the risk of collateral settlement fails because of the increased collateral movements that will result. The report estimates the annual exposure from collateral settlement failure on the sell-side is as much as $27 billion.
“The new CSAs under the regulation will change operational processes a lot as the number of collateral calls is expected to go up by 500%,” said McCormack. He added that he had not seen the start of a collateral squeeze among clients.
Nevertheless, both Jenkins and McCormack were optimistic about compliance by September.
“I believe the situation will be different in September because progress has to be demonstrated so a last-minute rush is less likely. If firms don’t start preparing now, one could argue that they are not compliant. I think it will be a smoother implementation in September,” McCormack said.
“I expect the disruption will not be too great in September. We’ve had several pieces of cumbersome regulation come in over the last five years, and the market is usually pretty resilient,” Jenkins concluded.