Beyond regulatory deadlines with collateral management strategies
To describe the financial services industry’s regulatory environment in recent years as overwhelming, daunting, or resource draining may all be considered understatements. Staying abreast of all the updates of proposed and final rules along with the multitude of jurisdictional variances, and then determining their operational, liquidity, and risk management impacts can require teams of resources.
A case in point would be the uncleared swap margin rules, which have potential global impact on dealers, buyside firms, outsourcers, custodians, and collateral management vendor operations. Driven by the BCBS-IOSCO recommendations, global regulators have established the parameters to improve management of both counterparty and systemic risk by requiring two-way gross initial margin, daily calculation and collection of Variation Margin, prescriptive eligible collateral, and segregation of initial margin.
To best manage resources and also prepare for the requirements, firms will need to determine the scope and impact the uncleared swap margin rules will have on their operations and trading, while also considering whether to adapt their clients’ investment strategies. The uncleared swap margin rules are driving tactical changes to meet compliance deadlines, but it is important to look beyond the deadlines and identify collateral management strategies to reduce costs while best managing liquidity and counterparty risks.
Firms need to determine which legal entities/accounts are in scope for the rules. Each jurisdiction has its own definitions based on respective securities laws and regulations, but generally, banks, investment funds, pensions, hedge funds, and insurance companies are subject to the rules.
Reviewing each legal entity’s accounts and counterparty relationships will help determine which jurisdiction’s rules will be applicable and if there are any cross-border issues due to disparate rule details.
Once a firm has identified which legal entities and accounts are subject to the rules, then the firm should review their trading strategies and derivatives inventory. For example, uncleared swaps will be in scope, including interest rate, credit default, equity, and commodity swaps and OTC options. FX swaps are within scope for determining the Average Aggregate Notional Amount for the Initial Margin phase-in timing and for Variation Margin requirements but physically settled FX swaps are not in scope for Initial Margin requirements.
CSA Re-Papering and Operational Impact
The documentation pipeline is underway with ISDA’s working groups driving initiatives for both Initial Margin and Variation Margin CSAs, and there will be an industry-endorsed method for sharing documentation. Even with the industry’s best efforts to streamline CSA re-papering, negotiations will be necessary for eligible collateral and termination rights between counterparties. Some trading and risk strategies will allow firms to simply amend their current CSAs and have one set per counterparty/account relationship, and some strategies will require that legacy transactions remain under one CSA, while new trades will need to be under a different CSA. If additional CSAs must be added, margin call and collateral settlement volume could increase by up to 100% - which will also increase the operational burden and further highlight the need for STP. It is then advantageous for firms to work with providers that have the experience and willingness to work with them through this complex process.
In the US and the EU, the rules are currently written to require T+1 settlement. This will require close oversight of valuation and collateral inventory data flow, along with margin call agreement and collateral settlement processing.
Although industry best practice has long been to calculate and exchange margin on a daily basis, some relationships and trading strategies have not justified that operational expense, such as relationships with low volume/low notional exposure or in products with low volatility where daily margin calls were not deemed necessary. Going forward however, rules will require both daily calculation and daily posting/collection of margin. Based on industry estimates, this has the potential to increase margin calls by up to five times, and even more for those accounts that don’t currently post initial margin or don’t post margin for FX NDFs. For example, for accounts that previously posted margin on a weekly basis, the daily requirement is estimated to increase margin call volume by up to 500%. Further, for accounts that didn’t post Initial Margin or for accounts that traded FX NDFs that didn’t post Initial Margin or Variation Margin, the daily volume will now increase their margin call volume exponentially.
Without Straight Through Processing (STP) or Tri-Party services, meeting the shorter settlement cycle and handling the increased margin call volumes will be very difficult with current staffing models and system infrastructures..
In addition to T+1 being an operational challenge, regulation will prescribe Minimum Transfer Amounts (MTA) and will combine both Initial Margin and Variation Margin. In some jurisdictions, the MTA must be calculated at the legal entity/consolidated financials level. In the case of separately managed accounts that have multiple investment managers for the same legal entity, the prescribed MTA will need to be allotted to each of the investment managers, the end client will need to review this data and inform each investment manager of their allotment every day, or firms may have to succumb to a very low MTA. As a result, settlement transfer volumes are likely to rise, requiring further STP, and real time settlement collateral confirmation will be imperative to best manage the new complexities of MTAs.
Although the EU has delayed its implementation of its uncleared swap margin rules, other jurisdictions stayed steadfast to the September 2016 Phase 1 date, which required large dealers to begin compliance for both Initial Margin and Variation Margin. However, it is still expected that all other covered swap entities must be ready to comply with the Variation Margin changes which come into effect in or around March 2017, with Initial Margin requirements phasing-in annually each September thereafter, depending on the entity’s notional size.
As described, the burden to prepare and implement a regulatory compliant solution is substantial. Its impact is felt beyond just the collateral management team, but effects risk, legal, valuations, etc. Therefore, it is imperative that firms should not delay. Ensuring operational, liquidity, and counterparty risks are all well-mitigated by leveraging industry utilities and collateral management services can help firms not only meet regulatory requirements but assist with strategic positioning as they move towards a holistic approach to collateral management.
Collateral Management 2.0
After years spent on managing regulatory initiatives and figuring out what to do, it’s time to focus on how to do it better and how to competitively differentiate yourself. Next generation collateral management, or Collateral Management 2.0, could be the answer, but how can you arrive at Collateral Management 2.0 with binding priority, time, and cost constraints?