This past fall, Phase 3 of initial margin reform came into force. All firms holding more than $1.5 trillion USD in notional in uncleared derivatives were required to post margin in a manner compliant with the rules of a new global margining framework. This new framework, passed by regulators in all major jurisdictions, is composed of stringent rulesets around what securities counterparties can post as collateral, what haircuts and concentration limits may be applied to that collateral, at what frequency and in what manner that collateral is to be posted in.  The framework is part of the set of regulatory reforms that continue to be implemented following the 2008 financial crisis, designed to maintain the integrity of the derivatives markets. 

The third of a five-phase implementation deadline, 1 September 2018 marked the end of days when posting initial margin under Uncleared Margin Rules (UMR) was a sellside-only issue. Brevan Howard became the first buyside to fall into scope on that date. A financial or non-financial counterparty falls under the scope if the entity has material swaps exposure regardless of role. Brevan Howard’s experience precipitates what will impact a large majority of investment managers and hedge funds as they prepare for initial margin compliance.  With the impending implementation of Phase 4 and 5 of IM reform, slated for 1 September 2019 and 2020, over 1,100 buysides are estimated to be impacted, barring any last minute regulatory relief. 

The task of preparing to post margin is as multifaceted for asset managers as it is for their dealer counterparts.  Credit Support Annexes (CSA) need to be negotiated and executed; eligible collateral schedules agreed upon; initial margin models selected; custodians contracted and integrated; and margin posting processes tested. Negotiations must be conducted by both parties who are required to post margin, doubling the amount of work.  Both sellside and buyside firms face these onerous tasks in order to achieve compliance. Asset managers unfortunately face a larger challenge as they typically have a smaller staff to deal with the same set of negotiation and regulatory requirements coupled with trying to streamline coordination between legal, operations and front office teams. There are a number of moving parts. 

Moving parts

The “to do” list for buyside firms impacted by UMR’s Initial Margin requirement is quite long

• agreeing upon the method of margin calculation (SIMM versus grid), the tenors and timelines attached to margin processing, noting any complex exceptions;
• acceptable security types and currency dominations of securities and cash to be posted as collateral;
• and perhaps trickiest, more consistency around the reference data attached to the constituent parts of these often-complex transactions.

For buyside firms managing a handful to 20+ of dealer relationships and multiple custodians—with each of them potentially using their own proprietary data schema and platforms—dealing with these requirements is extremely burdensome. 

For example, if you have agreed to posting cash USD and US Treasuries only with Dealer A, and posting cash EUR and European Central Bank Debt only with Dealer B, and expect to be posting initial margin with both dealers, this presupposes that you have put in processes to ensure that you hold enough of each currency and/or debt combination set available to post as needed, or have a facility to ensure that the currency conversion or sovereign debt purchase happens in an automated way that allows you to post in time to meet margin obligations.  

Posting cash in a currency other than the base currency can result in surprising haircuts of 8% so collateral selection is a key aspect to consider. If those facilities are not already in place, that and other processes needs to be set up quickly, prior to the phase-in UMR deadline applicable to your firm.  This is one of a myriad of examples of processes that must be set up well in advance of your applicable phase-in date.  With so many nuances in play, it’s little wonder that tightly-resourced operations and compliance teams are already feeling overwhelmed—even before the next phases go live.

The risk of delaying action

In the area of Initial Margin, where requirements have been seemingly ever-evolving, there is a tendency to take a “wait and see” approach.  The temptation is to put off any technology moves until absolutely necessary. Investment managers and institutional investors already need to be thinking about how to cope. There is simply a lot to do, and significant operational risk to manage - aggregating among sellside and custodial platforms, pulling in a wider range of technical details about margin agreements, linking data up with and flagging potential portfolio management consequences, and most importantly developing an end-to-end margin management process.

This drive should begin with fundamental questions about automation: digitalization of legal documents, bridging disparate data sources and portals, monitoring for scope and exceptions, and ultimately delivering this information to a wider mix of personnel and relevant systems—collateral management, risk, and even portfolio management, among others. The final stages of the UMRs will bring a need to adopt a new set of processes and technology that will impact firms for years to come.  Those taking a proactive approach to ready their legal and operational teams will be best placed to manage the new rules in a cost-effective way.