What should firms be doing to prepare for the final phases of initial margin? What do the final stages of implementation involve?
There’s a lot the industry still has to do in terms of setting up the tri-party relationships, both legal and operational. But the broader picture here is that many more firms in the industry are going to have to post more margin. In many places, the firms that are being impacted have never had to post margin before or on their bilateral trades.
For example, if they are a pension fund, they are very likely to have been trading with zero margin, and suddenly they are going to have start tying their assets and bonds up and actually posting them to their counterparties. There’s also the challenge of legally and operationally tying up balance sheets. A lot of the initial concern lies with the legal and operational side. They are the core basics that have to be in place to allow you to post margin—we focus in the area after that.
Once these assets start to be processed, you then have a slightly different problem which is essentially a knock-on impact, which is that you have more exposure to your counterparties as you’re actually posting your assets to them. Ultimately your leverage is being constrained.
You can’t use those assets in the way you used to be able to generate returns, and therefore it’s a returns problem that is created, that is the knock on impact of these regulations. Firms will realise this when they start to post.
What challenges are asset managers and pension funds facing in the lead up to the final phases of initial margin implementation?
Derivatives are becoming more and more expensive to trade. This is not just because of regulation. At the end of the day, when products become more expensive to trade, that is ultimately a returns problem.
While there are definitely benefits to regulation, in terms of making the system more robust, safer and more transparent, there are also material costs involved, which are just being passed down to the actual users of these products in terms of pension funds and asset managers.
At OpenGamma, we help our clients with return problems. We provide them analytics that give them ways to minimise the negative cost impact under new regulations. So for initial margin, in particular, we give clients mechanisms that allow them to reduce the impact of margin regulation.
Are the final phases more intense than previous phases, and why?
What’s different about phase 4 and 5 is the amount of firms being impacted who have never had to post margin before on their bilateral trades.
Hedge funds, for example, have, for the most part, already posted margin on these trades, whereas phase 4 firms have never had the infrastructure in place to have to post margin on bilateral trades.Therefore, it’s a much more significant change to their processing and an impact on their business.
Phase 1 and 2 firms were largely just banks that were already very well developed in this kind of area. They’ve been trading in this way for a long time and there was a much lower impact on them.
Could smaller companies suffer under phase 4 and 5?
It is becoming more and more expensive to trade. It’s also true that there are costs associated with complying. The bigger the firm, the more prepared they will be to deal with all the regulatory impacts that are hitting them. The smaller firms do suffer most because of the fixed cost associated, especially with onboarding and legal work. All these things are dependent on the size of the firm.
What happens if firms are unable to meet the September 2020 deadline? What are the consequences?
If we look at other regulations, the second Markets in Financial Instruments Directive (MiFID II) is a good example where there has been some leeway given to firms. With MiFID II, there wasn’t a hardline cut-off deadline where everyone had to demonstrate a very clear path of compliance.
Equally, the reputational impact of looking after someone else’s money and ability to comply with the regulation reflects your ability to run your business. While there is leeway in terms of physical compliance with phase four and five, the reputational impact alone means they’ll be a different kind of cost in failure to comply.
What opportunities will come from the final phases of initial margin implementation?
The underlying effect of these initial margin rules is to make bilateral trading more expensive because the intent of the regulation is to push more trading to clearinghouses from bilateral to cleared. Clearing comes with lots of benefits, but there are some concerns that have prevented firms from moving to that model.
In general, the intent is to move everything toward a central clearinghouse. Once you’re clearing there are benefits, not least, it’s an immediate way to reduce the amount of margin you have to post.
The bilateral margin is set up in a way to make it more expensive from a margin perspective, making an immediate margin saving. You get the benefits of credit risk and benefits of liquidity.
The single biggest benefit for a pension fund is a liquidity one, where they’re no longer locked into their bilateral trading relationships. They can exit trades with any counterparty, reducing the amount of locking they have on every trade they do to be more price competitive in their trading.
What would you advise to firms who are still unsure about these initial margin rules?
While there are core, operational and legal requirements up front, firms should be thinking about their mechanics—once they have the facilities in place to post margins, that’s going to have a material impact on their business.
You have to look across all these different ways that these products are traded, whether that’s exchange-traded, over-the-counter cleared, as well as bilateral. It’s only when you have the full picture you can then actually optimise the margin.
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