Non-cleared margin: the opportunity for securities finance
04 September 2018
Industry experts provide an insight into the main challenges the market faces today, including compliance with evolving regulation and managing cyber risk. But how are they navigating these waves of change?
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Without a doubt, the biggest issue facing collateral management today—and for the next couple of years—is the ongoing implementation of margin requirements on non-cleared derivatives in the majority of the world’s developed markets.
This process started in Pittsburgh in 2009, when G20 finance ministers met in the wake of the financial crisis to agree reforms designed to strengthen the global financial system.
Under the agreement reached at that summit, the future treatment of derivatives was to be two-pronged: standardised derivatives would be cleared at central counterparties, while non-standardised derivatives unsuitable for clearing would remain bilaterally traded and be subject to the mandatory exchange of both initial margin (IM) and variation margin (VM).
The first phase of the non-cleared margin requirements took effect in September 2016, as the largest US banks with notional derivatives exposure above $3 trillion began posting margin.
In September 2017, the threshold dropped to $2.25 trillion and dropped again to $1.5 trillion in September 2018, requiring a few dozen more institutions to comply.
In these first three waves, almost all of the entities captured were banks and broker-dealers, but events are poised to become much more interesting from here on out.
The number of impacted entities is expected to spike in September 2019 as the thresholds drop to $750 billion, but then expand dramatically in September 2020 as any market participants with derivatives notionals above just $8 billion will be included.
Although $8 billion is not a very large number in terms of notional derivatives exposure, a large swathe of buy-side firms have a little over two years to prepare themselves to meet the new margin requirements.
A rare opportunity
While the challenge of complying within that deadline is a significant one for impacted firms, it also presents a fantastic opportunity for beneficial owners and asset lenders not captured by the rules. This is because the changes are likely to drive a vast group of new participants to enter the securities finance market for the first time in order to meet their margin requirements.
To practically demonstrate the point, let’s take the example of an insurance company.
A US life insurer is running a large book of variable annuities for policyholders. The insurer hedges the interest rate risk posed by these annuities using bilaterally-traded long-dated swaps. Due to the notional swap exposure the insurer is running, it will be captured under the non-cleared margin requirements in 2019.
Both IM and VM will be required to be posted against these long-dated swap hedges, and arguably the simplest way for the insurer to access government securities and the other eligible collateral is to access the securities finance market.
However, the need to borrow securities from asset owners does not stop there. As the insurer’s older grandfathered swap hedges that are uncollateralised roll-off, they must be replaced by new in-scope hedges that require collateral.
Further, in the current rising interest rate environment, variable annuity books are more susceptible to market moves, meaning that the insurer will need to stockpile an inventory of eligible collateral assets in order to promptly post additional margin in response to VM calls upon changing market dynamics.
Collateral shortfall
With such a marked increase in the amount of collateral required by just a single institution, concern has been expressed in recent years over the total volume of collateral that compliance with the non-cleared rules will consume.
A wide variety of numbers have been quoted on the aggregate collateral drain the new rules will entail. In 2012, research firm TABB Group estimated the shortfall at $1.6 to $2 trillion, while the following year the Committee on the Global Financial System, a subsidiary of the Bank for International Settlement, put the number as high as $4 trillion.
Some of this demand has already been digested by the market during the first two waves of non-cleared margin compliance in 2016 and 2017 as the largest banks and broker-dealers were impacted.
Based on flows observed internally within BNY Mellon, certainly, hundreds of billions of dollars in additional high-quality collateral has been sourced by counterparties over the past two years—with the number perhaps having already exceeded the $1 trillion mark.
Despite the progress we’ve already seen, there is much more activity to come as hundreds of buy-side firms begin the compliance process. This promises to be a hugely positive development for beneficial owners and asset lenders, as they are well-positioned to capitalise on the increased demand to borrow collateral assets in the years ahead.
The non-cleared margin journey
To provide a sense of the many stages involved in complying with the non-cleared margin rules—and to demonstrate where the opportunity lies for beneficial owners—here is a brief step-by-step guide.
Pre-trade
Am I included? The process begins with this simple question. If a trading entity’s derivatives exposure exceeds the threshold for inclusion, they’re captured.
Custodian selection: Captured entities need a third party custodian to which collateral is posted. Custodians with large securities lending programmes may prove particularly useful in sourcing eligible collateral for clients.
Select segregation model: Most custodians offer a choice of segregation models. At BNY Mellon, clients can choose either: Triparty Segregation, which handles many processes on clients’ behalf, including identifying unencumbered assets, screening assets and applying haircuts, or; Margin DIRECT, in which clients have a more direct hand in controlling the collateral workflow.
Collateral schedule: Collateral schedules need to be agreed between trading counterparties, specifying the types of securities each are willing to accept as collateral and the applicable haircuts and concentration limits.
Trade execution
Calculating margin: Following execution, a margin call is issued from the trade counterparty requesting a certain amount of collateral. The entity on the other side of the trade will need to verify that it agrees with the calculation—requiring either internal capabilities or the assistance of a third-party collateral administrator.
Dispute resolution: If there is a discrepancy between the two margin calculations, a mechanism—such as a reconciliation service—will be required to resolve the dispute.
Eligibility analysis: With the margin amount agreed upon, each party has to determine the eligible collateral the other is willing to accept and compare it against the securities in their custody account.
Collateral selection and transformation: This is where the opportunity lies for asset lenders and beneficial owners. Let’s imagine that a counterparty will only accept US Treasuries, but the client’s portfolio only contains corporate bonds and equities.
In this case, the client’s options are to either buy treasuries (assuming it has ready cash available) or sell securities to fund the purchase, which is something the client does not want to do.
Securities finance presents a third option. As one of the world’s largest agent lenders, BNY Mellon can connect the client with one of the market’s largest communities of beneficial owners and asset lenders.
As non-cleared margin rules drive more buy-side entities into borrowing assets through securities finance, BNY Mellon sits at the centre of a network providing borrowers with the collateral they need, and providing lenders with a potential source of additional yield, creating solutions for the needs of both parties.
Deliver and receive assets: With the eligible margin assets sourced, the collateral is delivered to both counterparties’ segregated accounts at their designated custodians.
Post-trade
Post-settlement obligations: For each trade, counterparties are required to mark-to-market every live position every day, and post or receive VM accordingly. This will be an ongoing requirement that will necessitate daily and intra-day maintenance.
Connecting lenders and borrowers
Whether you are a buy-side party in line to be impacted by the non-cleared margin rules, a broker-dealer already subject to the requirements, or an out of scope asset manager, the changes to come in the next two years will make securities lending an even more invaluable service for market participants than ever before.
If the higher collateral shortfall estimates prove to be correct, the requirements will present a once-in-a-generation opportunity for beneficial owners to capitalise on these hugely favourable market dynamics as incremental demand for more high-quality collateral only heightens in the market.
As BNY Mellon continues work to onboard more buy-side clients into our collateral administration service, we are adding more potential borrowers to participate in securities finance.
On the other side, we continue to induct new asset owners into our agency lending programme, ensuring that we’ll be able to connect holders of margin assets with those that will need collateral going forward.
That is good news for beneficial owners, good news for buy-side borrowers, and good news for the stability of global markets.
This process started in Pittsburgh in 2009, when G20 finance ministers met in the wake of the financial crisis to agree reforms designed to strengthen the global financial system.
Under the agreement reached at that summit, the future treatment of derivatives was to be two-pronged: standardised derivatives would be cleared at central counterparties, while non-standardised derivatives unsuitable for clearing would remain bilaterally traded and be subject to the mandatory exchange of both initial margin (IM) and variation margin (VM).
The first phase of the non-cleared margin requirements took effect in September 2016, as the largest US banks with notional derivatives exposure above $3 trillion began posting margin.
In September 2017, the threshold dropped to $2.25 trillion and dropped again to $1.5 trillion in September 2018, requiring a few dozen more institutions to comply.
In these first three waves, almost all of the entities captured were banks and broker-dealers, but events are poised to become much more interesting from here on out.
The number of impacted entities is expected to spike in September 2019 as the thresholds drop to $750 billion, but then expand dramatically in September 2020 as any market participants with derivatives notionals above just $8 billion will be included.
Although $8 billion is not a very large number in terms of notional derivatives exposure, a large swathe of buy-side firms have a little over two years to prepare themselves to meet the new margin requirements.
A rare opportunity
While the challenge of complying within that deadline is a significant one for impacted firms, it also presents a fantastic opportunity for beneficial owners and asset lenders not captured by the rules. This is because the changes are likely to drive a vast group of new participants to enter the securities finance market for the first time in order to meet their margin requirements.
To practically demonstrate the point, let’s take the example of an insurance company.
A US life insurer is running a large book of variable annuities for policyholders. The insurer hedges the interest rate risk posed by these annuities using bilaterally-traded long-dated swaps. Due to the notional swap exposure the insurer is running, it will be captured under the non-cleared margin requirements in 2019.
Both IM and VM will be required to be posted against these long-dated swap hedges, and arguably the simplest way for the insurer to access government securities and the other eligible collateral is to access the securities finance market.
However, the need to borrow securities from asset owners does not stop there. As the insurer’s older grandfathered swap hedges that are uncollateralised roll-off, they must be replaced by new in-scope hedges that require collateral.
Further, in the current rising interest rate environment, variable annuity books are more susceptible to market moves, meaning that the insurer will need to stockpile an inventory of eligible collateral assets in order to promptly post additional margin in response to VM calls upon changing market dynamics.
Collateral shortfall
With such a marked increase in the amount of collateral required by just a single institution, concern has been expressed in recent years over the total volume of collateral that compliance with the non-cleared rules will consume.
A wide variety of numbers have been quoted on the aggregate collateral drain the new rules will entail. In 2012, research firm TABB Group estimated the shortfall at $1.6 to $2 trillion, while the following year the Committee on the Global Financial System, a subsidiary of the Bank for International Settlement, put the number as high as $4 trillion.
Some of this demand has already been digested by the market during the first two waves of non-cleared margin compliance in 2016 and 2017 as the largest banks and broker-dealers were impacted.
Based on flows observed internally within BNY Mellon, certainly, hundreds of billions of dollars in additional high-quality collateral has been sourced by counterparties over the past two years—with the number perhaps having already exceeded the $1 trillion mark.
Despite the progress we’ve already seen, there is much more activity to come as hundreds of buy-side firms begin the compliance process. This promises to be a hugely positive development for beneficial owners and asset lenders, as they are well-positioned to capitalise on the increased demand to borrow collateral assets in the years ahead.
The non-cleared margin journey
To provide a sense of the many stages involved in complying with the non-cleared margin rules—and to demonstrate where the opportunity lies for beneficial owners—here is a brief step-by-step guide.
Pre-trade
Am I included? The process begins with this simple question. If a trading entity’s derivatives exposure exceeds the threshold for inclusion, they’re captured.
Custodian selection: Captured entities need a third party custodian to which collateral is posted. Custodians with large securities lending programmes may prove particularly useful in sourcing eligible collateral for clients.
Select segregation model: Most custodians offer a choice of segregation models. At BNY Mellon, clients can choose either: Triparty Segregation, which handles many processes on clients’ behalf, including identifying unencumbered assets, screening assets and applying haircuts, or; Margin DIRECT, in which clients have a more direct hand in controlling the collateral workflow.
Collateral schedule: Collateral schedules need to be agreed between trading counterparties, specifying the types of securities each are willing to accept as collateral and the applicable haircuts and concentration limits.
Trade execution
Calculating margin: Following execution, a margin call is issued from the trade counterparty requesting a certain amount of collateral. The entity on the other side of the trade will need to verify that it agrees with the calculation—requiring either internal capabilities or the assistance of a third-party collateral administrator.
Dispute resolution: If there is a discrepancy between the two margin calculations, a mechanism—such as a reconciliation service—will be required to resolve the dispute.
Eligibility analysis: With the margin amount agreed upon, each party has to determine the eligible collateral the other is willing to accept and compare it against the securities in their custody account.
Collateral selection and transformation: This is where the opportunity lies for asset lenders and beneficial owners. Let’s imagine that a counterparty will only accept US Treasuries, but the client’s portfolio only contains corporate bonds and equities.
In this case, the client’s options are to either buy treasuries (assuming it has ready cash available) or sell securities to fund the purchase, which is something the client does not want to do.
Securities finance presents a third option. As one of the world’s largest agent lenders, BNY Mellon can connect the client with one of the market’s largest communities of beneficial owners and asset lenders.
As non-cleared margin rules drive more buy-side entities into borrowing assets through securities finance, BNY Mellon sits at the centre of a network providing borrowers with the collateral they need, and providing lenders with a potential source of additional yield, creating solutions for the needs of both parties.
Deliver and receive assets: With the eligible margin assets sourced, the collateral is delivered to both counterparties’ segregated accounts at their designated custodians.
Post-trade
Post-settlement obligations: For each trade, counterparties are required to mark-to-market every live position every day, and post or receive VM accordingly. This will be an ongoing requirement that will necessitate daily and intra-day maintenance.
Connecting lenders and borrowers
Whether you are a buy-side party in line to be impacted by the non-cleared margin rules, a broker-dealer already subject to the requirements, or an out of scope asset manager, the changes to come in the next two years will make securities lending an even more invaluable service for market participants than ever before.
If the higher collateral shortfall estimates prove to be correct, the requirements will present a once-in-a-generation opportunity for beneficial owners to capitalise on these hugely favourable market dynamics as incremental demand for more high-quality collateral only heightens in the market.
As BNY Mellon continues work to onboard more buy-side clients into our collateral administration service, we are adding more potential borrowers to participate in securities finance.
On the other side, we continue to induct new asset owners into our agency lending programme, ensuring that we’ll be able to connect holders of margin assets with those that will need collateral going forward.
That is good news for beneficial owners, good news for buy-side borrowers, and good news for the stability of global markets.
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