Neil Murphy, OSTTRA triResolve Business Manager, sat down with Risk.net for this Q&A to discuss how buy-side firms should prepare for uncleared margin rules, implementation priorities for phase six firms and how vendors are adapting their services to ease the process of managing derivatives portfolios and collateral.
What has phase five taught us about how buy-side firms should prepare for uncleared margin rules (UMR), and what impact is the increasing volume of firms having on the industry?
Neil Murphy: Similar to phase five, a large proportion of phase six firms foresee their IM exposures remaining below the €50 million regulatory threshold for some time, allowing them to take advantage of regulatory relief. However, phase six firms should proceed with caution. For some phase five firms, IM exposure increased much faster than anticipated, necessitating the exchange of collateral, which for some also required a scramble to complete legal documentation and custodian onboarding. Reasons for this include market volatility, unexpected growth in new business and, for some, a poor upfront understanding of standard initial margin model (Simm) calculation. To ensure market access in the weeks and months after the deadline, firms should establish baseline documentation with a subset of counterparties and begin steps for custodian onboarding. As more firms fall into scope, the industry faces increased complexity with juggling the documentation challenge. That so many phase five firms deferred IM credit support annex (CSA) documentation prior to September 1, 2021, creates a legal hangover, with phase six firms now competing not only with each other, but also with phase five firms seeking to paper with their counterparties. Even phase six firms that are happy to defer formal IM documentation may find themselves caught up in delays to agree informal monitoring terms, as dealers face enquiries from hundreds of counterparties simultaneously.
What should the implementation priorities be for phase six firms ahead of the September 2022 deadline?
Neil Murphy: Early estimation of IM should be a priority for phase six firms. Once this is known, firms can assess the broader impact on each portfolio, determining which relationships require legal documentation or whether they can take advantage of regulatory relief. To be ready in time to guide the project, firms will probably need to have completed this step early in the second quarter of 2022. At that point they should also be making good progress in terms of onboarding, if leveraging an external IM provider. Other implementation priorities – such as custodian onboarding or collateral preparations – are determined by the early estimation of IM exposure. Given lengthy custodian onboarding timelines, firms expecting to require a custodian from day one should prioritise this. Firms expecting to monitor only may be well advised to review custodian documentation, select a preferred provider and undertake preliminary onboarding steps.
What factors do phase six firms need to consider in their choice of margin model?
Neil Murphy: When selecting a margin model, a key factor is the model’s ‘fit’ for a specific portfolio (in some cases Simm may be lower or higher), but a more crucial factor is a firm’s ability to support that model – either via existing risk platforms or the use of a dedicated IM calculation engine. If using Simm, firms must also consider the added complexity of the calculation, as well as additional market data requirements. Firms may also find themselves required to meet regulatory governance requirements, where they must provide additional documentation to support their choice of model, ongoing risk governance and backtesting of IM results. The key question for phase six firms is: ‘Which model allows me to take advantage of regulatory relief for the longest period?’, with a broad assumption that, in most cases, the Simm methodology will result in lower IM exposure, providing a longer grace period. For portfolios where Simm does not provide significantly lower numbers, firms can choose the simpler approach of Grid methodology.
How is UMR changing the way firms manage their derivatives portfolios and collateral?
Neil Murphy: UMR can lead to changes in firms’ behaviour, pre- and post-trade. From a pre-trade perspective, some firms are seeking to avoid UMR completely by reducing their average aggregate notional amount (AANA) ahead of May 31, reducing the size of their portfolios via compression or, where possible, moving to clear more trades. However, once in-scope, some firms seek to optimise IM by assessing which counterparty a trade should be booked with, either taking advantage of regulatory thresholds with a broad range of counterparties or selecting a portfolio where the IM impact will be minimised. While the forced switch to non-cash collateral might appear the biggest change for many collateral managers as part of UMR, the most significant impact is one of technology, as firms play catch-up to improve their operational capacity, streamline processes and adopt industry standards.
How are vendors adapting their services to ease the process for phase five and six firms? Which innovations have made the greatest impact?
Neil Murphy: For many phase five/six firms, UMR presents an opportunity to re-evaluate their broader collateral technology stack. UMR-specific requirements such as IM margin workflows and support for non-cash collateral sit alongside broader requirements for end-to-end automation, connectivity to industry reconciliation platforms, electronic messaging and Swift settlement. Helping firms prepare requires a fast and simple adoption path, which is likely to necessitate the use of cloud technology. Firms now recognise that this path allows them to quickly follow regulatory change with immediate access to new features. Key changes noted among phase five/six firms include new requirements to dynamically monitor IM exposure – alerting users when predefined tolerances are breached – and new requirements to provide clients with automated connectivity to a range of custodians and tri-party agents via Swift. OSTTRA has observed that settlement automation has provided perhaps the biggest win for clients, with our turnkey Swift access eliminating the need for complex integration with multiple custodians, syncing margin and settlement workflows, removing dependency on fax, automating collateral payments and providing real-time settlement insight.