By Scott Fitzpatrick, Director of Collateral Business and Client Operations, AcadiaSoft
We are now in the final phases of the implementation of the new margin rules for uncleared over-the-counter (OTC) derivatives transactions that were introduced globally in 2016. Phase 4 comes into effect in September 2019, and Phase 5 in September 2020.
Which firms will fall within the scope of these final phases? Specifically, what will firms that fall under the rules have to do to comply? And when should they start preparing?
First, a bit of background; although every local prudential regulator was responsible for drafting and implementing its own detailed version of the uncleared margin rules (UMR), the various rules are all based on a framework created by the Basel Committee on Banking Supervision (BCBS) and the International Organisation of Securities Commissions (IOSCO) in response to the G20’s reforms introduced after the 2008 financial crisis.
The rules require financial firms and “systemically important non-financial entities” to post initial margin (IM) and variation margin (VM) when trading uncleared OTC derivatives. The posted margins are intended to ensure that enough collateral is available to offset any losses caused by trading disputes or by the default of a counterparty in an uncleared OTC derivatives trade, thus reducing systemic risk in the market and incentivising central clearing. This puts uncleared OTC derivatives on a similar footing with centrally-cleared OTC derivatives, where strict margin rules already exist.
Currently, the VM rules apply to all firms, but the IM rules apply only to entities trading aggregate average notional amounts (AANA) of uncleared OTC derivatives in excess of €1.5 trillion. These are all major sell-side banks and broker-dealers, plus a few large buy-side firms.
When Phase 4 comes into effect this coming September, the IM rules will apply to firms with notional amounts above €750 billion; however most buy-side firms will still be exempt because of their lower trading volumes. Approximately 35 firms are expected to fall under IM Phase 4.
Phase 5, however, will be a game-changer. It presents new legal and operational challenges for the vast majority of buy-side firms. Under Phase 5, the rules will apply to firms with notional amounts above €8 billion, capturing all but the smallest buy-side firms. From that date, in-scope firms will have to post IM to dealers and receive IM from dealers in all cases where their IM exposure exceeds €50 million. Collecting IM from a dealer is a totally unfamiliar process to almost all buy-side firms.
So how should these smaller buy-side firms approach the challenges of Phase 5 compliance? To begin, they will need to understand their portfolios, what their AANAs are and whether they will fall under Phase 4 or Phase 5. They will have to make sure they have the correct legal documentation in place with their trading counterparties, the large banks that were in-scope for IM in prior phases. They must also be aware of how many of their trading relationships will be above the €50 million IM threshold, the level at which an exchange of initial margin is required.
There are multiple other steps to complete, such as establishing relationships with relevant custodians, building up capacity for compliance and last-minute testing before the deadline kicks in. Isda, the International Swaps and Derivatives Association, has produced a useful eight-step guide to help Phase 4 and 5 firms prepare. (AcadiaSoft also has an IM compliance guide, UMR Compass).
There are also many other resources available through AcadiaSoft, the industry collaborative through which 99% of Phase 1, 2 and 3 firms are currently achieving UMR compliance. AcadiaSoft is also focused on helping buy-side firms prepare to meet this new challenge and has been reaching out to firms to capture information that will help identify whether they fall under Phase 4 or 5. Over the next year and half, AcadiaSoft plans to devote a significant amount of time and resources to help buy-side firms prepare for Phase 5.
AcadiaSoft has established market-wide working groups dedicated to the buy-side firms that fall under the scope of the regulations. In the coming months, AcadiaSoft will hold workshops and host road shows in key financial centers around the world to explain to firms what they should be doing to prepare for Phase 5.
With entities such as Isda, AcadiaSoft and others stepping forward to assist, even smaller buy- and sell-side firms are in a position to inexpensively and efficiently comply with the UMRs by the September 2020 deadline. But given their complexity, the time to begin preparing for these changes is now.