SunGard’s Ted Allen explains why market participants should start preparing their collateral management programs to support BCBS/IOSCO’s non-cleared margin requirements now and offers advice for how firms should start their compliance plans
Q. December 1st 2015 seems like a long way off. Why do firms need to start preparing to comply with the non-cleared derivatives margin requirements set out by the Basel Committee on Banking Supervision (BCBS) and the International Organization of Securities Commission (IOSCO) now?
A. Just over a year is not enough time given the breadth of change needed to comply with the new margin requirements for non-cleared derivatives. Firstly, there is legal and infrastructure change that needs to begin immediately including the negotiation of new or existing collateral agreements, establishing the segregation of initial margin and setting up custody accounts. To give you an idea of the scale of the change, a survey conducted by the International Swaps and Derivatives Association (ISDA) estimated there were 240,000 legal agreements that need to be renegotiated before the December 1st 2015 deadline, which is a difficult task due to the legal resources required in a short timeframe.
In addition to the legal and infrastructure challenges, new requirements will call for technological change or system upgrades to support new processes needed to comply with the new rules. For instance, asset-pricing modelling is required because collateral will soon be priced into the trades requiring the use of robust and sophisticated pricing models. This is just one example though. For many firms, such radical change will necessitate that in-house collateral management systems and vendor services be upgraded or replaced entirely.
ISDA has raised concerns with the regulators about the planned implementation date and asked for a delay in a recent letter to the BCBS/IOSCO asserting that the proposed timeframe is too tight and the December deadline clashes with ‘code freezes’ at the end of the calendar year. However, there is no confirmed delay in the proposed deadline.
Q. What is the first step a firm should take in creating a compliance plan? How far progressed are most firms?
A. The first step is to identify the internal operational processes that will be affected, which procedures need to change and to ensure a firm fully understands how their counterparties will implement their own plans. The regulatory regimes of the US and Europe need a coordinated implementation process across all market participants but today there are still differences to contend with. For example, the US interpretation of the rules treat USD denominated collateral differently to Europe. The rules continue to be challenged by the industry but of course the implementation plans must be flexible to accommodate possible changes in the near future.
As software vendors we deal with participants actively re-evaluating their collateral management infrastructure after having acknowledged some existing systems are not fit for purpose. Many firms are using the regulatory imperative to review their entire collateral management infrastructure and replace the systems that cannot be compliant. Others have not set aside the IT resources yet, but will have to do so imminently if they are looking to work with existing internal collateral management systems. Those firms with vendor platforms must ensure the enhancements are included in the vendor road map and upgrade plans. At SunGard we have ring-fenced these resources to help our clients become compliant ahead of the deadline.
Q. Will firms have to change how collateral management is organised?
A. The new regulations will increase the velocity at which collateral will move. Collateral management will require more involvement of the front office and risk teams whilst also increasing the total pressure on a firm’s liquidity – all changes that will alter the way collateral management is organised. The amount of collateral required will increase for many firms as a result of initial margin rules and restrictions on re-hypothecation in Europe and the US. Thus assets set aside for initial margin will remain static or unused. Collateral optimisation which in some cases currently is seen as a luxury will be essential in a post-IOSCO regime.
Firms will also be more reliant on internal risk management tools which will need to be adapted to produce initial margin calculations. Even with standard models provided by market utilities, firms will still need to replicate these models if they are to understand on a pre-trade basis the initial margin impact of new trade. This is essential for pricing, funding and selecting a counterparty to execute the trade with the aim to reduce overall initial margin and to forecast how they might evolve under stressed market conditions.
Q. What is the short-term impact of these requirements on collateral management processes?
A. In the short-term collateral management teams need to set aside legal resources for papering and re-papering legal agreements and to ensure they fully understand the rules before building an implementation plan.
For firms who are unable to upgrade their collateral infrastructure in time, there will be manual workarounds required. For instance, many legacy collateral management platforms will struggle with monitoring group level initial margin thresholds and making currency level variation margin calls.
There will also be huge volume spikes in the number of margin calls. Each collateral agreement will require a variation margin call for each currency bucket. In addition, for those firms subject to the initial margin requirement, there will also be two initial margin calls required. This will have a much bigger impact on operations than central clearing because of the volume implications and because with clearing, much of the complexity has been outsourced to the clearing houses.
Q. What is likely to be the biggest challenge firms face when changing collateral management processes? What challenges do you face when helping clients prepare?
A. The biggest challenge for the buy side will likely come from getting the people and the systems they will need to manage these new requirements. Collateral management is not a core function for many and getting the right expertise and tools in-house will be a stretch.
The fluid nature of the regulations, which are already being challenged and may change between now and the implementation date, creates uncertainty in the industry at large. When we look at the delays over the implementation of central clearing requirements in Europe, we can imagine there will be several iterations of the BCBS IOSCO rules before we have an end date so more delays to contend with.
We spend a lot of time educating clients about the requirements and the expected impact; however, the message hasn’t been received by all and others may underestimate the scale of change needed.
Q. What are the related market initiatives participants should be aware of?
A. As collateral requirements increase, ensuring there is adequate liquidity will become ever more important. Collateral initiatives introduced by International Central Securities Depositories (ICSDs) are an interesting approach to addressing these problems and ensuring that collateral can move freely around the system. Removing the friction from the market and cutting settlement times will make collateral optimization more of a reality and we will start to see the velocity of collateral movements increasing.
Q. What advice would you give our readers as to what they should do now to start preparing their collateral management operations to comply by December 2015?
A. My last minute advice is that firms need to review the proposed regulation now. They should understand the likely implications and identify internal processes that need to change. Many firms have not done this review yet. Once this is complete, they need to look at collateral and liquidity management systems and determine if they are fit for purpose. Only then can a strategy be established and implementation begin.
