The lengthy rollout of the Uncleared Margin Rules (UMR) enters its final phase in September 2022, bringing its six-year implementation journey to an end with perhaps the most talked-about leg of all. And although September might seem like a far off date, it is time for every fund manager to assess whether their funds will be affected by Phase 6 of the regulation.
Hedge fund and asset managers at approximately 1,100 buy-side firms will be affected by this final chapter, and in similar fashion to MiFID, firms not only have to comply, but they must also overhaul their business processes.
Unlike MiFID, which saw non-compliance resulting in a possible fine, doing so with UMR Phase 6 could result in trading with some or all counterparts being frozen entirely. Because of this, it is necessary for firms to ensure they meet compliance requirements before it is too late.
The first three phases of UMR implementation mainly impacted firms with the largest non-cleared portfolios: such as major bank groups, global dealers and a few buy-side players. However, since Phase 4, the buy-side has started to be phased into the Standard Initial Margin Model (SIMM) calculations.
The Aggregate Average Notional Amount (AANA) for the respective phases decreased from $750 billion in Phase 4 to $50 billion in Phase 5, which resulted in a much greater number of firms being brought into the scope of the regulation; representing the first significant impact on the buy-side. The number of firms affected will continue to increase in Phase 6 as it will impact those with an AANA above $8 billion, or an equivalent measure in non-USD jurisdictions, from spring 2022. Phase 6 will largely affect buy-side firms including hedge funds, asset managers, insurers, pension funds and energy firms, among others.
Although Phase 6 will impact the largest number of firms to date, it may not necessarily be the most challenging phase for those involved. It could be argued that Phase 6 firms may have an easier path in achieving compliance, mainly because it has already been done before by firms in previous phases.
A trip down memory lane
When Phase 1 was first initiated, everything to do with the calculations, the regulation itself and its processes were new and untested, which presented a challenge to the firms impacted by the phase. Firms affected by Phase 6 will now be able to learn from those who have worked toward reaching compliance and avoid any initial mistakes they may have made. Achieving UMR compliance today has become a well understood issue which many industry players, utilities and consultancies can assist Phase 6 clients with. Today, these firms have a selection of providers to choose from who can assist with providing the necessary tools for Initial Margin (IM) calculation and SIMM reconciliation; multiple options for collateral segregation exist; and counterparties who have already gone through steps of compliance can be observed as a learning curve.
Neil Murphy, business manager for triResolve and triOptima within OSTTRA (a post-trade joint venture owned 50/50 by CME Group and IHS Markit), notes that Phase 6 firms can also benefit from regulatory guidance which would allow firms to defer the opening of custody accounts or signing documentation with counterparties ahead of the implementation date, should they expect to remain below the $50 million threshold. “However, this guidance also creates a quandary for firms: are they confident that their IM exposure will be low enough to allow them to take advantage of this deferral; or should they plough on ahead and complete all preparations now?” he says.
“Knowing whether they should ‘stick or twist’ creates a new challenge, one that requires IM calculation as soon as possible on either current or simulated portfolios.”
When looking at how Phase 1 went down, it is worth noting that only a handful of firms were affected. These firms were huge financial institutions which were able to dedicate a large quantity of resources towards tackling compliance. At the other end of the spectrum, Phase 6 will impact around 1,100 smaller buy-side firms and, comparatively, many of these may not have the luxury of dedicated compliance teams.
During the months of March, April and May 2022, AANA calculations will be made which will allow firms to understand whether their entity groups are in scope for UMR for their respective jurisdictions. However, knowing whether a firm is likely to be in scope before this period will be beneficial, as it will give them ample time to prepare for compliance. This will include setting up segregated margin accounts with custodians, establishing new UMR compliant legal agreements with trading counterparties and calculating IM numbers through the SIMM or GRID calculation.
The latter can be quite a difficult process, however, a wide range of vendor solutions exist to help with both calculating IM numbers as well as the model validation of chosen SIMM models. In Europe, another step to achieve compliance will involve providing a backtest and model validation of firms’ SIMM governance framework.
Cost of compliance
The cost of compliance is something that is difficult to explicitly quantify, as the actual cost can vary greatly depending on the firm. During Phase 1, dealer banks compliance programmes were said to potentially reach costs that were over $100 million, whereas in Phase 6, a small hedge fund could achieve compliance for less than $250,000. Costs of compliance really depend on a given firm’s trading activity: including the complexity of its portfolios and how many jurisdictions it trades in; in-house expertise; and the chosen technology solutions a firm deploys to help achieve compliance.
“Over the course of the UMR phase-in we’ve seen many firms use the upcoming IM compliance requirement as an opportunity to improve associated processes, largely with respect to VM processing, but also reconciliation and settlement,” adds Murphy.
“Such an approach can include maximising the use of a single vendor relationship to deliver the widest set of functionalities, improve connectivity and straight through processing and reduce the number of vendor relations and overall complexity.”
The timeframe needed to achieve compliance to an extent mirrors the nature of cost of compliance, in that it may depend on the scope of the firm. However, several custodians and other industry utilities have set deadlines of March 2022 for Phase 6 clients to begin onboarding.
Firms that are already in-scope have advised that preparing for UMR compliance could take over 12 months, emphasising how important it is for firms to already be in the process of working towards compliance. The suggested time reflects the countless steps needed to prepare: such as implementing new systems, legal negotiations and custodian onboarding, as well as the actual time required to coordinate stakeholders. And although the majority of firms have made tasks such as IM calculation a priority, sufficient time needs to be allocated for system testing.
“If firms haven’t started their UMR projects already then they are starting to run very short on time. Whilst the project itself may take around six months, because of the scale of task for the industry as a whole, this timeline has become extended and needs to be started as soon as possible,” says Thomas Griffiths, head of product, Cassini Systems.
Although several months remain between now and the September deadline for UMR Phase 6, the high number of firms this phase impacts could lead to troubles down the line due to the limitation of industry resources. UMR bottlenecks could potentially occur due to the increase in the number of firms Phase 6 will impact. With compliance requiring collaboration between a wide variety of industry stakeholders including counterparties, custodians and vendors, as well as the affected firms themselves, some timings may be beyond their control, and this needs to be factored into the timeline.
“One thing is clear – there is a huge amount to do for all the various players. Six months, including a summer period just before the go-live deadline, is very little time for a regulatory compliance project with such extreme consequences of non-compliance,” says Griffiths.
These consequences could include a ban on trading bilateral derivatives for firms that do not meet the September deadline, which could seriously limit their access to market. In terms of IM CSA negotiation, counterparties may be less flexible or only offer triparty collateral segregation. Meanwhile, custodians may not guarantee that accounts will be opened before the implementation date. In addition, vendors may limit IM calculations to schedule method as opposed to SIMM, which could possibly result in increased IM costs.
There are, however, ways in which firms can continue trading – for example, by taking advantage of the UMR threshold of $50 million. IM does not need to be posted until this threshold is crossed, meaning firms would be able to trade with their counterparts up until this IM amount has been reached.
“By setting up lighter agreements with their counterparts that allow them to trade up until they approach this threshold, firms are able to delay parts of the legal documentation the custodian set up process until after September 1st, 2022,” says Griffiths.
“However, this isn’t a shortcut, there is still a requirement to calculate the IM amount, and under this approach it is incredibly important to understand where you are versus the threshold so that you are ready to become fully compliant quickly in the event that you are within striking distance.”
One thing is certain. UMR Phase 6’s implementation date of September 2022 is going to come around a lot sooner than you think, and all impacted firms should already be in the process of preparing. For those who have not yet begun, it may be a tight race to the finish – and a stressful one at that.