With phase 6 of the Uncleared Margin Rules (UMR) looming, we look at the impact of the rules since they were introduced in September 2016 and consider what in-scope firms should be addressing and the challenges they face.
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Article: Looking ahead to the last phase of UMR
At its core, collateral management encompasses a set of relatively standardized but distinct and fragmented, operational tasks. Regardless of a firm’s size, those tasks will likely include:
Collateral automation should ideally target each of these tasks – allowing each to be performed directly, while simultaneously connecting each task – thus enabling straight-through processing with zero, or minimal, user intervention. Put more simply, users should not be required to load data, initiate tasks, approve workflow items, or manually book payments. Instead, they should be focused on exceptions and reduction of risk.
Automation should also include reporting and connectivity to other functions – including risk, accounting, and payments.
As someone who started their career in collateral management using Excel for margin calculations and sending calls via fax, it’s true to say I’ve seen a fair amount of progress over the years. However, there’s still room for improvement because way too many firms still rely on outdated manual processes.
Step back in time five years and the barrier was plain and simple. There were limited, or no options, for collateral automation available in the market. While technology now provides a multitude of automation options, some firms are unfortunately still slow to adopt.
The first – and perhaps most worrying barrier – is a failure to recognize that the existing operational setup creates unnecessary work and increases risk, the so-called ‘head in the sand’ problem. Or similarly, that firms have not stayed up to date and are in the dark about the new automation options available to the industry.
Those who recognize that automation would benefit their firm but still not able to move forward often cite ‘other project priorities’ as a blocker. To them, I’d gently suggest, ‘if not now, then when?’ Similarly, many firms suggest budget constraints are holding them back. However, given the emergence of cloud and web-based collateral services such as OSTTRA triResolve Margin, this barrier is rapidly diminishing as the industry moves away from upfront licence fees and costly long-term contracts.
For firms who use in-house or installed vendor solutions, new automation will typically require an upgrade or waiting for the build-out of new features, creating its own barrier to adoption.
The final barrier is perhaps more of a cultural or organizational challenge, characterized by a reluctance to embrace change, or perhaps a failure to truly understand the benefits of automation. The arguments ‘we’re not that big, automation doesn’t really matter for us’, ‘we’ve always done it this way’, or ‘it’s an audit requirement to do it this way’ remain strong, despite the glaring benefits from automation, to firms of all sizes.
Perhaps the most critical reason to automate was highlighted by the COVID-19 pandemic. A perfect storm of market volatility and remote working left many firms struggling to meet capacity and called attention to both a high dependency on manual processing and limited capacity to deal with a spike in volumes. Going forward, an inability to send out margin calls on time, coupled with a counterparty default, could have significant impact on a firm. Rather than wait for the next market stress, firms should undertake steps to automate their processes as quickly as possible, thus providing greater future resilience.
With both buy- and sell-side firms increasingly impacted by regulation (UMR, SFTR, LIBOR transition), the day-to-day demands on a collateral manager are increasing, so automation is vital to meet increased workloads and regulatory objectives. Firms subject to new IM requirements under UMR potentially face increases in call volumes, settlements, and reconciliations as well as the additional effort of preparing to comply.
Similarly, automation can support business scalability, allowing front office to trade more products with an increased number of counterparties. With increased operational volumes, the risk of manual processing errors (incorrect or failed payments, etc.) rises too, so automation should be seen not only as a solution to deliver more bandwidth but to mitigate the risk of error too.
While the above should provide more than enough to support a firm’s business case for automation, there’s also the human element. For reasons of both staff retention and professional development, moving away from manual processing may result in higher levels of satisfaction, as employees are tasked less with clicking buttons and more with managing risk and exceptions.
Rather than simply automate the current process, firms should use the opportunity to review their end-to-end flow, ensuring it can support business growth and regulatory change. While the target should be end-to-end automation, each firm should identify those aspects they want to prioritize, for example, improved dispute resolution or reduced failed payments.
Perhaps the most critical focus, is to ensure firms adopt existing industry standards and best practice. Standardized solutions exist for reconciliation (OSTTRA triResolve), margin call messaging (Acadia), and settlement (SWIFT), thus providing coverage for much of the operational flow. Adoption of these can provide a fast-track to automation and help reduce costs.
Implementing these standards is one thing, but firms must also focus on connectivity. A piecemeal approach, consisting of multiple providers will likely require more effort to maintain – with the added potential for multiple points of failure – whereas a single provider offering can deliver off-the-shelf connectivity combined end-to-end functional support.
While UMR largely impacts firms for IM purposes, one observation OSTTRA has made over the various phases of UMR to date, is that many clients have chosen to onboard well ahead of their IM deadline. Thus, gaining immediate VM automation benefits and ensuring improved capacity to help deliver IM compliance when the time comes. So rather than consider compliance through a narrow lens only (meeting IM objectives), firms should look at the potential for automation across the entire collateral management process, including dispute resolution.
For more information on initial margin compliance, click here or contact us at info@osttra.com.
Many firms will face the new requirement to calculate and monitor Initial Margin (IM), and for those where IM is expected to exceed regulatory limits, they must also sign new legal documentation, open custodian accounts and prepare to exchange collateral.
We can help you prepare, providing a complete set of tools for IM calculation, monitoring, margining, settlement, dispute management and backtesting – automated and seamless – UMR untangled.
New uncleared margin rules (UMR) require in‑scope users of over-the-counter derivatives to post and collect initial margin (IM) – in addition to the current exchange of variation margin (VM) – and are expected to have a long-standing operational impact. As a minimum, firms will be required to manage increased data flows and margin calculations, while firms that exceed regulatory thresholds face an increase in the number of margin calls and settlements they must perform. In some cases, this will lead to call volumes tripling as firms move from managing one daily margin exchange per portfolio (VM) to three (VM as well as two non-netted regulatory IM calls).
Firms impacted by earlier UMR phases typically focused on calculating IM, as well as other upfront tasks such as custodian onboarding and legal documentation. Collateral management and downstream impact were frequently considered secondary priorities. However, firms in-scope through phases one to four included many of the largest firms. Typically, these firms already benefited from high levels of margin automation, which largely explains why they were relatively less concerned about additional operational impact on collateral.
Ahead of phase six, the key question is whether smaller firms in phase six have the levels of operational capacity and automation to cope with UMR.
Regulatory relief means phase six’s impact on firms will vary – some will be required to post IM soon after the compliance deadline, while for others this may take years, if it happens at all. Even those that expect minimal impact must ensure they can support additional challenges around calculation and IM monitoring, while others must prepare to support the complete IM collateral flow. Regardless of the expected impact, phase six firms must urgently review their entire end-to-end collateral flows for both IM and VM.
Manual processes for collateral management are nothing new. In a 2017 paper, the International Swaps and Derivatives Association (Isda) noted pain points across the margin lifecycle, from VM calculation and call processes, to asset selection and collateral settlement, to margin interest calculation. The paper describes “antiquated, legacy processes that require substantial updates”, and recommends “automation of the front-to-back collateral process allowing for a virtual zero-touch environment”. Five years on, how much of this work has been completed by phase six firms?
For many, operational processes have remained largely untouched for years, characterised by the manual calculation and exchange of margin calls. Reliance on emails for margin call exchange can lead to lengthy processing times, increased risk of user error and higher costs. In addition, the settlement process is often disconnected from the margin flow, requiring additional manual processing and increasing the risk of settlement failure. While the European Market Infrastructure Regulation and Dodd-Frank rules have done much to mandate portfolio reconciliation, some still deviate from industry norms and the use of shared platforms, increasing not only their own operational efforts, but those of their counterparties too. It is likely many of these firms are still some distance from the zero-touch processing Isda called for in 2017.
For many, back-office changes have not been a priority to date because of competing priorities, a feeling that volumes haven’t necessitated an overhaul and a historical perception that the project and technology costs required for change are perhaps more expensive than operational costs.
However, phase six firms should learn from those impacted by earlier phases. Successful UMR compliance is about much more than IM calculation and, wherever possible, firms should use the regulatory deadline as an opportunity to transform and upgrade their collateral operations capabilities. While UMR may not mandate collateral automation, business demands may require it. UMR compliance will require a new focus: firms must support larger operational volumes, shorter settlement windows, larger amounts of collateral being exchanged and, for many, a switch from cash to securities collateral, as well as new requirements to segregate collateral.
For some, existing operational weaknesses were highlighted by the Covid‑19 pandemic, where dependency on manual processing required more bodies at desks. This is in contrast to firms with high levels of straight-though processing (STP), which were able to transition to remote working more quickly. Similarly, these firms are often those most stretched during periods of market volatility as margin call numbers increase quickly.
In reviewing the lessons learned from earlier phases, many firms took a proactive approach, using the regulatory deadline as an opportunity to drive operational and technology changes. For many, this focused not only on changes to meet new IM tasks, but on broader transformation that updated their wider VM and dispute capabilities. The consistent theme has been that many firms recognised a need to improve their existing infrastructure and operations to support the expected increase in volumes – whether driven by new agreements, calculations, margin calls, settlement or simply monitoring new IM exposures.
Automation can mean different things to different people and, historically, some may have been satisfied that an emailed margin call was sufficiently ‘automated’. However, it is important that firms take a broader industry-wide view to understand the full potential for automation.
Taking the negotiation of new IM legal documentation as a starting point for UMR, this can already be negotiated via the Isda Create portal, allowing firms to move away from the legacy exchange of drafts and amendments via email. While the IM calculation itself may be owned by the risk department, firms must ensure this flows directly from the risk engine to the collateral system, allowing firms to automatically monitor exposure (where IM remains below €50 million) or calculate any margin requirements due. An integrated technology approach – often from a single provider – can reduce integration points and deliver more STP.
A margin call workflow is another essential tool, providing not just a robust approach to managing calls, but ensuring a clear audit trail too. Central to firms’ workflows should be the use of electronic messaging to exchange calls – email should be used as a last resort. To date, margin messaging has been the norm for exchange of IM calls in earlier phases. Messaging allows firms to maximise STP, supporting real-time exchange of margin calls, which, when combined with workflow automation, means margin calls can be completed in seconds rather than hours. A move away from manual processing should allow firms to automatically send and agree calls and, where required, identify key IM and VM dispute drivers.
The final step in the margin lifecycle is collateral exchange and settlement, which is typically constrained by a manual process to select and pledge collateral, and is further limited by reliance on legacy settlement processes – which, in many cases, still depends on the use of fax or manual booking of payments. Automation enhancements should include leveraging the system to optimise and book collateral movements, as well as synchronising the margin and payments workflows, using Swift for instruction of payments. Not only will this ensure STP and lower the risk of failed payments, but it will increase transparency by providing real-time settlement status – allowing firms to move away from assumed settlement – and the capture of tri-party collateral allocations.
Recent technological advances and broader adherence to industry standards mean the entire margin process can now be automated. Rather than build custom automation, firms can leverage shared infrastructure to fast-track this journey. This approach ensures firms can stay up to date, with immediate access to the latest features, ensuring automation across the margin lifecycle, including connectivity to risk engines, counterparties, reconciliation platforms and custodians.
In addition to the obvious time savings automation can deliver, it can also help firms reduce processing costs and is a critical step towards optimisation – which can itself deliver further collateral cost reductions. From a user perspective, automation can help teams focus on higher-value activities and – by removing the legacy of manual processing – can lead to higher rates of job satisfaction.
Used wisely, automation can deliver increased efficiency and greater time savings across all margin activities. By focusing on the entire collateral process – rather than purely IM – firms can achieve quick returns on their current VM processes, creating more bandwidth to help prepare for UMR and cope with increased challenges after the September 1 deadline.
Tools to help firms solve these common problems are widely available, while greater use of shared services and industry standards means the cost of change may quickly be recouped.
For more information regarding our UMR solutions, please email info@osttra.com or click here.
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.
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.
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.
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.
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.
For more information regarding our UMR solutions, please email info@osttra.com or click here.
Watch our interactive online briefing to learn more about January’s record-breaking SA-CCR cycle and other recent initiatives. We cover the major topics likely to be a priority for you in 2022, following a review of 2021 highlights.
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