Initial margin: The final straight
19 November 2020
BNP Paribas collateral gurus offer a look at the final phases of the Uncleared Margin Rules and examine the road ahead for those affected
Image: stock.adobe.com/EpicStockMedia
The decision to delay full implementation of margin requirements for non-centrally cleared derivatives has been welcomed by the industry. Not only does it avoid a last-minute rush in the context of the 2020 financial crisis but it represents an opportunity for firms to rethink their approach to derivatives.
Preparing September 2021 wave
In April 2020, the Basel Committee and the International Organization of Securities Commissions (IOSCO) announced a further extension to the final implementation phase of the initial margin (IM) requirements for derivatives contracts that are not cleared through a central counterparty. These requirements are designed to reduce systemic risks related to over-the-counter (OTC) derivatives markets, as well as provide financial institutions with appropriate incentives for central clearing while managing the overall liquidity impact of the requirements.
As defined in April 2020, covered entities with an aggregate average notional amount of non-centrally cleared derivatives that are greater than 鈧�8 billion (phase six firms), become subject to the requirements from 1 September 2022. Meanwhile, the 1 September 2020 deadline is postponed to 1 September 2021 for phase five firms, with a threshold of 鈧�50 billion.
David Beatrix, head of product, Collateral Access, at BNP Paribas Securities Services, describes these delays as a sensible response to concerns that the pandemic crisis may slow down firms鈥� preparation to new rules, especially buy-side ones.
鈥淎t the root of this reform is a desire to move from a 鈥榮urvivor pays鈥� principle, to a 鈥榙efaulter pays鈥� principle, to avoid firms using their own capital to absorb losses implied by a counterparty bankruptcy. Another effect is that this will also promote central clearing,鈥� he explains. 鈥淭here is a realisation on the part of the Basel Committee and IOSCO that IM compliance is not just a copy-and-paste of the variation margin (VM) process; it is a new process with a steep learning curve.鈥�
The margin requirements for non-centrally cleared derivatives are broadly aligned across North America, Europe and Asia Pacific, although there are nuances with regard to exemptions. For example, equity options are out of the scope of margin requirements in the US rules, but were only exempted in the EU up until 4 January 2020.
Who鈥檚 affected?
Among the buy-side community, asset owner institutions (particularly insurance companies, pension schemes and sovereign wealth funds) are expected to be the most affected by the changes because of the size of their derivatives positions and their consolidation under one single entity, says Beatrix. Asset managers will only be impacted if they have delegated mandates from asset owners or if they manage funds that use OTC derivatives above the 鈧�8 billion threshold, which remains rare.
Furthermore, when asset owners delegate the management of their assets 鈥� usually across multiple managers 鈥� they also often delegate middle and back-office functions. This can make it challenging to calculate IM due to the potential for fragmented calculations across multiple managers.
鈥淲e have already had discussions on this topic with clients who are tempted to replicate what they already do on VM 鈥� in other words, to leave their investment managers to manage the VM independently from each other,鈥� Beatrix explains. 鈥淭his works well for VM because numbers are additive, but IM is a risk-based calculation and, as such, fragmenting the calculation process can involve higher IM amounts once accumulated across investment managers.鈥�
Optimising collateral
Another issue on which BNP Paribas Securities Services can guide clients is collateral optimisation. The market is concentrated around securities as collateral, but many phase five and phase six firms do not necessarily own large volumes of these financial instruments so may have securities that are not considered eligible by a counterparty.
J茅r么me Blais, head of business development and client solution, triparty collateral at BNP Paribas Securities Services, observes that although cash is acceptable according to the regulations, counterparties prefer not to have cash left on the books of their custodian.
鈥淲e are working with firms to combine custodial and collateral management services with collateral transformation,鈥� he says. 鈥淭his means that when clients require high-quality liquid assets, they can initiate an order to our trading desks to convert less liquid or less highly-rated assets into high-quality assets to be posted to their counterparties.鈥�
Beatrix adds: 鈥淚n addition, we are helping those who find it challenging to fully implement UMR by calculating IM amounts using industry standards and connecting to market utilities which are key to margin and portfolio reconciliations.鈥�
Testing ideas
Blais explains that firms are increasingly viewing his team as a resource, where they can test ideas.
鈥淲e have been spending an increasing amount of time this year supporting clients as they determine the most effective model for their business, whether that is triparty, using an outsourcer for collateral management or developing their own system in-house,鈥� he says. 鈥淭his is also why we made the strategic decision to invest in a triparty collateral service, which has created the fifth global offer on the market.鈥�
鈥淭his was a sensible move given that in Europe, triparty now accounts for more than 95 percent of IM,鈥� he adds.
Critics鈥� concerns
Inevitably, the new margin requirements for non-cleared derivatives have not been universally welcomed.
鈥淲hile the objectives are praiseworthy, we must also recognise that they don鈥檛 address demands to raise the thresholds to avoid having so many counterparties becoming subject to margin requirements,鈥� says Blais.
There is also some concern around possible future treatment of cross-currency swaps. The Basel Committee and IOSCO have said they will evaluate the risks of not subjecting the fixed physically-settled foreign exchange transactions associated with the exchange of principal of cross-currency swaps to the IM requirements.
Then there is the cost factor. The buy-side often seeks a directional position to hedge risk or take a specific view on some assets or groups of assets, which could imply some significant IM numbers. As a result in many cases, posted collateral implies a net funding cost, which cannot be compensated with collateral received, as the latter is simply not reusable.
Careful planning required
鈥淢ost of the industry has opted for the SIMM or standard IM model because it recognises risk offsets, which is an important factor for banks, and for the industry as a whole. It implies that if you have a market risk-neutral portfolio, the IM numbers are going to be lower, which will minimise funding costs,鈥� says B茅atrix.
He also refers to firms taking the opportunity to review their roster of service providers.
鈥淭hey may have realised that they have a reason to take a strategic look at their service model and implement a more streamlined approach across the entire chain of services,鈥�
B茅atrix notes.
While phased implementation of the final stage of the new margin rule should reduce the incidence of rushed implementations, it is vital that buy-side firms continue to push ahead with their compliance planning. Reorienting derivatives activity is not achieved overnight 鈥� it requires months of careful planning.
Preparing September 2021 wave
In April 2020, the Basel Committee and the International Organization of Securities Commissions (IOSCO) announced a further extension to the final implementation phase of the initial margin (IM) requirements for derivatives contracts that are not cleared through a central counterparty. These requirements are designed to reduce systemic risks related to over-the-counter (OTC) derivatives markets, as well as provide financial institutions with appropriate incentives for central clearing while managing the overall liquidity impact of the requirements.
As defined in April 2020, covered entities with an aggregate average notional amount of non-centrally cleared derivatives that are greater than 鈧�8 billion (phase six firms), become subject to the requirements from 1 September 2022. Meanwhile, the 1 September 2020 deadline is postponed to 1 September 2021 for phase five firms, with a threshold of 鈧�50 billion.
David Beatrix, head of product, Collateral Access, at BNP Paribas Securities Services, describes these delays as a sensible response to concerns that the pandemic crisis may slow down firms鈥� preparation to new rules, especially buy-side ones.
鈥淎t the root of this reform is a desire to move from a 鈥榮urvivor pays鈥� principle, to a 鈥榙efaulter pays鈥� principle, to avoid firms using their own capital to absorb losses implied by a counterparty bankruptcy. Another effect is that this will also promote central clearing,鈥� he explains. 鈥淭here is a realisation on the part of the Basel Committee and IOSCO that IM compliance is not just a copy-and-paste of the variation margin (VM) process; it is a new process with a steep learning curve.鈥�
The margin requirements for non-centrally cleared derivatives are broadly aligned across North America, Europe and Asia Pacific, although there are nuances with regard to exemptions. For example, equity options are out of the scope of margin requirements in the US rules, but were only exempted in the EU up until 4 January 2020.
Who鈥檚 affected?
Among the buy-side community, asset owner institutions (particularly insurance companies, pension schemes and sovereign wealth funds) are expected to be the most affected by the changes because of the size of their derivatives positions and their consolidation under one single entity, says Beatrix. Asset managers will only be impacted if they have delegated mandates from asset owners or if they manage funds that use OTC derivatives above the 鈧�8 billion threshold, which remains rare.
Furthermore, when asset owners delegate the management of their assets 鈥� usually across multiple managers 鈥� they also often delegate middle and back-office functions. This can make it challenging to calculate IM due to the potential for fragmented calculations across multiple managers.
鈥淲e have already had discussions on this topic with clients who are tempted to replicate what they already do on VM 鈥� in other words, to leave their investment managers to manage the VM independently from each other,鈥� Beatrix explains. 鈥淭his works well for VM because numbers are additive, but IM is a risk-based calculation and, as such, fragmenting the calculation process can involve higher IM amounts once accumulated across investment managers.鈥�
Optimising collateral
Another issue on which BNP Paribas Securities Services can guide clients is collateral optimisation. The market is concentrated around securities as collateral, but many phase five and phase six firms do not necessarily own large volumes of these financial instruments so may have securities that are not considered eligible by a counterparty.
J茅r么me Blais, head of business development and client solution, triparty collateral at BNP Paribas Securities Services, observes that although cash is acceptable according to the regulations, counterparties prefer not to have cash left on the books of their custodian.
鈥淲e are working with firms to combine custodial and collateral management services with collateral transformation,鈥� he says. 鈥淭his means that when clients require high-quality liquid assets, they can initiate an order to our trading desks to convert less liquid or less highly-rated assets into high-quality assets to be posted to their counterparties.鈥�
Beatrix adds: 鈥淚n addition, we are helping those who find it challenging to fully implement UMR by calculating IM amounts using industry standards and connecting to market utilities which are key to margin and portfolio reconciliations.鈥�
Testing ideas
Blais explains that firms are increasingly viewing his team as a resource, where they can test ideas.
鈥淲e have been spending an increasing amount of time this year supporting clients as they determine the most effective model for their business, whether that is triparty, using an outsourcer for collateral management or developing their own system in-house,鈥� he says. 鈥淭his is also why we made the strategic decision to invest in a triparty collateral service, which has created the fifth global offer on the market.鈥�
鈥淭his was a sensible move given that in Europe, triparty now accounts for more than 95 percent of IM,鈥� he adds.
Critics鈥� concerns
Inevitably, the new margin requirements for non-cleared derivatives have not been universally welcomed.
鈥淲hile the objectives are praiseworthy, we must also recognise that they don鈥檛 address demands to raise the thresholds to avoid having so many counterparties becoming subject to margin requirements,鈥� says Blais.
There is also some concern around possible future treatment of cross-currency swaps. The Basel Committee and IOSCO have said they will evaluate the risks of not subjecting the fixed physically-settled foreign exchange transactions associated with the exchange of principal of cross-currency swaps to the IM requirements.
Then there is the cost factor. The buy-side often seeks a directional position to hedge risk or take a specific view on some assets or groups of assets, which could imply some significant IM numbers. As a result in many cases, posted collateral implies a net funding cost, which cannot be compensated with collateral received, as the latter is simply not reusable.
Careful planning required
鈥淢ost of the industry has opted for the SIMM or standard IM model because it recognises risk offsets, which is an important factor for banks, and for the industry as a whole. It implies that if you have a market risk-neutral portfolio, the IM numbers are going to be lower, which will minimise funding costs,鈥� says B茅atrix.
He also refers to firms taking the opportunity to review their roster of service providers.
鈥淭hey may have realised that they have a reason to take a strategic look at their service model and implement a more streamlined approach across the entire chain of services,鈥�
B茅atrix notes.
While phased implementation of the final stage of the new margin rule should reduce the incidence of rushed implementations, it is vital that buy-side firms continue to push ahead with their compliance planning. Reorienting derivatives activity is not achieved overnight 鈥� it requires months of careful planning.
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