Buy-side firms face up to operational challenges of incoming collateral rules

Despite the extension to comply with the final phase of the uncleared margin rules, major operational challenges remain for buy-side firms.

In July 2019, the Basel Committee on Banking Supervision (BCBS) along with the International Organisation of Securities Commissions (IOSCO) provided a respite for firms caught out by the incoming bilateral margining rules for non-centrally cleared derivatives.

For phase 5 firms, which include small-sized asset managers and pension funds, who were expected to begin bilateral margining in September 2020, the regulators raised the AANA (aggregate average notional amount) threshold for uncleared derivatives last year from EUR 8 billion to EUR 50 billion. Simultaneously, entities (now known as phase 6 firms) holding more than EUR 8 billion of uncleared swaps were given a one-year delay to get their operations in order. Despite the extension, major challenges remain.

“Most of the impacted firms already have the requisite operational processes and infrastructure in place to ensure compliance, but the real challenge will come when the threshold drops to an AANA of $8 billion in September 2021,” commented John Straley, executive director, institutional trade processing at the DTCC.

“At that point, it is estimated that several hundred smaller firms will be affected, a group likely to include regional banks and smaller asset managers that have not historically exchanged initial margin and therefore, do not have the third-party operational processes in place to manage collateral.”

Although there are exemptions, the new margining obligations will impact a number of instruments including interest rate derivatives, credit derivatives, FX derivatives, equity derivatives and commodity derivatives.

“While the delay provides these phase 6 firms with more time to prepare, it is vital that this time is used wisely given the scale of work necessary to meet the deadline. This will require some firms to change their business model. Those market participants should be preparing now – first, to establish whether they are in scope and if so, to tackle the steps necessary to meet the 2021 deadline,” said Straley.

Firstly, firms will need to examine whether their holdings exceed the EUR 8 billion threshold. “This task could prove daunting for multi-managed pools of assets, as the closely guarded distribution of assets across multiple managers is key to the successful returns that some of these pools generate year after year. In order to meet the Phase 6 deadline, this analysis needs to begin as soon as possible,” acknowledged Straley. 

After this assessment is finalised, organisations will need to disclose their status on in-scope entities to their counterparties and then reach consensus with them on how initial margin is calculated, determine minimal transfer amounts and initial margin thresholds, and agree on eligible collateral and haircuts. When complete, firms will then have to establish custodial relationships, which can be a lengthy process in itself involving contracts and negotiations.

“Once the custodial relationship is in place, firms must address operational resources to ensure they have the requisite workflows and processes in place to meet their compliance obligations. Firms will have to negotiate the necessary documentation for the preparatory steps, which may involve revisiting contracts that have remained unopened for up to a decade. Once these steps have been completed, market participants must ensure enough time remains for testing their new processes ahead of the Phase 6 deadline,” added Straley.

However, asset managers could avoid being tied up by the regulation altogether, according to collateral management technology provider OpenGamma. A recent study conducted by the firm of 300 firms that fall under the final two phases of the requirements found 74% of asset managers could optimise their portfolios to trade certain derivatives that are ‘free of margin’. The study added asset managers would be able to reduce the amount of upfront collateral that needs to be posted by ensuring they do not exceed the EUR 50 million threshold.

“No investor wants their managers tying up unnecessary capital that could be used for generating returns. The $50m threshold was created by regulators in an attempt to avoid unnecessary operational costs on smaller firms and asset managers should be using it to their advantage,” said Peter Rippon, CEO, OpenGamma.

“With the right analytics, our study shows that the majority of asset managers pulled into the next phases can identify which trades to move not only to make better use of the threshold, but to significantly reduce the amount of margin they post or eliminate it all together.”