Shaun Murray of Margin Reform explains how the fifth and sixth phases of uncleared magin rules will affect repo and securities lending
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How will the uncleared margin rules (UMR) phase five and six affect repo and securities lending?
From the buy-side point of view, this will be determined by whether the firm has access to collateral that is eligible for initial margin (IM) and whether that is agreeable to their counterpart during the IM negotiation.
For example, if they have a portfolio of treasuries, or other high-quality liquid assets (HQLA), there should be no issue. If they are using non-HQLA to post non-regulatory independent amount (IA) and these meet the eligibility criteria for regulatory IM, then this should be acceptable.
For those firms without this type of portfolio, there are a few choices:
Utilise repo and securities lending to switch or upgrade to collateral that is eligible in line with IM requirements.
Consider using cash products (money market fund) as eligible collateral, this could also form part of a collateral switch.
Negotiate with the dealers to widen the eligible collateral schedules to suit their requirements and utilise assets that they already hold.
Of course, as the cost pressures of IM becomes less palatable to individual organisations then optimisation will come to the fore as different techniques are used to balance the books.
One other indirect but related impact will be on Securities Financing Transactions Regulation (SFTR) and Central Securities Depository Regulation (CSDR) and the settlement of the two-way IM exchange.
How will UMR affect the trading of non-centrally cleared over-the-counter transactions?
The buy-side has been impacted by regulation far later than the sell side, and in that period trading derivatives has become more complex and the costs of trading have increased. It was expected that cleared versus uncleared would always see cleared as the cheapest and more viable option, the reality is that this is not always the case.
For products where clearing is not mandated, understanding the access your clearing broker has to different venues, plus the associated fees and costs should be compared to a bilateral trade, where you potentially post IM under Standard Initial Margin Model (SIMM) to a segregated account at a custody agent for the benefit of your potential insolvency. These form some part of the pre-trade analytics that could and should be performed.
Noting that, for non-centrally cleared, we have seen a market move to clearing in certain foreign exchange products such as non-deliverable forwards (NDF) which is in a large part attributable to the SIMM numbers. There are a couple of things to take away from this:
That costs have increased to a point where understanding how and where you can clear NDF’s has become a higher priority on the to-do list.
That there is an increased focus on collateral and margining costs.
What UMR challenges are the buy-side facing?
The buy-side already post IA to the dealer community, sometimes this is segregated, sometimes not. Therefore, transitioning to regulatory IM should not mean a huge change to their balance sheets, however, the effort and complexity involved in getting ready for segregated two-way IM requirements are vast.
At Margin Reform we reference the ‘Wheel of Pain’ (see figure 1) and the nine key points to compliance. This commences with the stages of self-disclosure, client engagement, and regulatory understanding before you consider the legal documentation and custodial requirements.
Further, you have to understand whether your technology stack is fit-for-purpose and how you will deal with the multiple new operational processes which flow across the organisation such as pricing, IM risk sensitivity generation and post-trade, settlement and collateral management.
We have had different discussions and heard many different views on how firms can achieve compliance. Educationally, it feels like there is a way to go to get the requisite knowledge to a level where phases five (1 September 2020) and six (1 September 2021) will be as smooth as we would all like.
It has been suggested that the buy-side is focusing on the replacement of Libor and overlooking UMR’s September 2020 deadline, do you agree?
Without a doubt, there is a huge amount of focus on the move away from Libor, and rightly so.
The results from the ISDA consultations are due to be published in Q3 alongside a new ISDA supplement and protocol, which is expected to become effective in Q1 2020, meaning transitioning away from Libor is likely to commence much earlier than the 2021 date referenced.
In a lot of firms, complex regulatory deliveries tend to utilise a number of the same people from business, technology, and change teams and with the effective date now accelerating, it is not a surprise that the conversations have gotten more focused to IBOR.
That being said, we believe there are a couple of areas, technology and legal documentation specifically, which with the right planning could benefit from a joint delivery.
What will the penalties of non-compliance with UMR phase five be?
Compliance isn’t optional. There has been a huge amount of industry advocacy over the past six months to try and ease the compliance burden.
This led to a couple of statements from the Basel Committee on Banking Supervision and the International Organisation of Securities Commissions. The upshot of the statement can be split into three points.
Legacy contracts: If amending legacy derivative contracts solely to address interest rate benchmark reforms, you are not required to apply margin requirements for UMR.
This position will need to be clarified under each relevant jurisdiction.
Acting diligently: In phase five (and now six) IM requirements will involve IM documentation, custodial and operational arrangements.
It was noted that if you are not going to exceed the framework’s €50 million IM threshold, then you needn’t be expected to complete all the documentation. However, as a covered entity, you are expected to act diligently.
Phase six: The final implementation phase for IM has been extended to 1 September 2021. Covered entities with an aggregate average notional amount (AANA) of non-centrally cleared derivatives greater than €8 billion will then be subject to the requirements.
The change to facilitate this extension is the introduction of an additional implementation phase on the 1 September 2020 (phase five), when covered entities with an AANA of non-centrally cleared derivatives greater than €50 billion will be subject to the requirements.
It is possible that we may see additional clarifications on the regulatory wording, for example, some questions have been raised about the European Markets Infrastructure Regulation Refit and IM model approval which remains a grey area.
A shot across the bows of non-compliance has already been given by the National Futures Association (NFA) and a fine issued.
It was found that inadequate processes and validation techniques had been used to assess the risks of the UMR margin model and that the necessary operational steps had not been taken to satisfy the initial margin and variation margin collection requirements.
What does the future of collateral management look like?
Collateral management should be regarded as a horizontal across any organisation. Collateral is a product in its own right, whether it’s the repo and securities finance market or the derivatives, futures and cash markets.
At every point, if you consider all of the pre-trade elections that are now possible and in a lot of instances required before execution, you realise that these are all inextricably linked to the post-trade impacts on treasury, optimisation, and liquidity and this is before you get to the additional operational and risk complexity that UMR adds to the equation.
In summary, collateral is here to stay, and, whatever your role in an organisation you will be impacted by it, affected by and likely working to understand it better and educate on it.
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