By Jack Callahan, Executive Director, OTC Products, CME Group
A change to the margin mandate for uncleared derivatives reduces the number of affected firms from 1,100 to 200
Market participants are moving to futures and compression services to reduce the value of derivatives portfolios
A number of financial firms required to post initial margin on uncleared derivatives received some welcome news in July. The next phase of the initial margin rules – applying to firms that have derivatives portfolios with over $8 billion in notional outstanding – was modified so that the majority of these market participants would have another year before they had to comply.
The regulation for uncleared margin rules (UMR) was set in motion at the 2009 G20 meeting following the global financial crisis. It requires firms using over-the-counter derivatives to post margin on those transactions. Phases 1 to 4 have covered firms with $750 billion+ in notional value.
Industry estimates from a September 2018 Isda letter estimated that over 1,100 newly in-scope counterparties would become subject to initial margin rules by the time Phase 5 came to fruition in September 2020.
The New Magic Number
The Basel Committee on Banking Supervision (BCBS)/IOSCO announcement on July 23 is expected to make Phase 5 of Initial Margin apply to far fewer firms, as it establishes the $50 billion Average Aggregate Notional Amount (AANA) as the new magic number for UMR compliance in 2020. It also laid out a revised measurement period for some jurisdictions such as the United States, where clients will now measure their AANA from March-May 2020 in line with the European Union, instead of the previous window of June-August 2019 for US clients.
200 Affected By Phase 5
An October 2018 analysis by economists at the Commodity Futures Trading Commission (CFTC) estimates that while Phases 1 to 4 capture just over 40 entities, Phase 5 (the old Phase 5 of $8B) could bring 700 entities in scope. Based on their analysis of CFTC data, over 75 percent of entities coming into scope in Phase 5 have AANAs less than $50 billion, implying that the new Phase 5 would include at least 175 entities.
However, while the measurement period is not until 2020, preliminary analysis of trades currently submitted to TriOptima’s triResolve portfolio reconciliation service shows approximately 200 clients would be subject to the new Phase 5.
A Change in Trading Behavior Coming?
To borrow some option terminology, having the threshold at $50 billion instead of $8 billion puts a larger number of clients closer to being “at the money” of the threshold level. This increases the value of notional reduction opportunities like switching volume to listed futures and cleared swaps and utilising multilateral compression.
Several market participants told CME Group they would have been captured in Phase 4 of UMR because they would be over $750 billion in AANA, but they were able to change the product mix of what they traded in order to reduce their notional and remain out of scope of Phase 4. The latest estimates show that because of these notional reduction efforts, Phase 4 will now only impact approximately 25 clients instead of the 50+ that were initially anticipated.
In our business, we have witnessed this with clients who started using FX futures instead of forwards, Equity Total Return Index Futures instead of total return swaps, and clients who backloaded their entire portfolios of Chilean Peso and Colombian Peso interest rate swaps into CME Clearing in order to get their notional amounts below the Phase 4 AANA threshold.
Suffice it to say that since the advent of UMR, there has been a definite movement from clients out of bilateral markets and into futures and cleared swaps.
Looking at the Large Open Interest Holders for CME Group financial products, there has been tremendous growth in holders of CME Group futures with over 1,300 new large open interest holders across equities, interest rates and foreign exchange futures since the start of 2016.