Broker dealers are on the last lap to meeting the September uncleared margin requirements but there are still a few hurdles left. Lynn Strongin Dodds looks at the areas that need to be addressed and the various paths participants are taking.
As the September deadline encroaches, the larger broker dealers are in the final stretch of preparations to meet the new margin requirements for uncleared OTC derivatives. Firms are relying on their own internal resources but there are also solutions on the market. However, getting everyone on the same page particularly in terms of data and calculations will not be so straightforward.
Market participants agree though that the exchange of variation and initial margin are two of the biggest operational hurdles emanating from the European Market Infrastructure Directive (EMIR) which has been guided by the Basel Committee on Banking Supervision (BCBS) and the International Organisation of Securities Commissions (BCBS-IOSCO). While broker dealers know their way around the former, which aims to protect against fluctuating market prices on a daily basis, initial margin is unknown territory for many and will require tougher calculations based on consistent methodologies.
In addition, sell-side firms will have to develop new collateral segregation arrangements that allow for immediate availability of margin so that both parties to the transaction are adequately protected in the event of default. This is not even mentioning the processes and systems that need to be upgraded or implemented to meet the clearing obligation, reporting and compliance requirements.
Although the checklist of things to do may be long, “this has not come out of the blue,” says David Clark, Chairman of the Wholesale Markets Brokers’ Association, a London based trade group. “Everyone knew it was going to happen and that banks have been getting ready to support and report margin. However, the concern is that it will be a disincentive to hedge and this will lead to an increase in risk across the board which is one of the unintended consequences.”
“Everyone knew it was going to happen and that banks have been getting ready to support and report margin. However, the concern is that it will be a disincentive to hedge and this will lead to an increase in risk across the board which is one of the unintended consequences.” – David Clark, Chairman of the Wholesale Markets Brokers’ Association.
The first group are those with an exposure of €3 trn under The European Securities Market Authority (ESMA) or $4 trn under the Commodities Future Trading Commission (CFTC) as measured during the March-May period preceding 1 September 2016. The threshold declines each successive year until September 2020 when most covered entities will have to comply. They have been getting their houses in order for the past couple of years while they wait for the final details to emerge but as with many pieces of regulation, it is those on the lower size rungs that are lagging behind.
Regardless of size, mounting costs are one of the results of the regulatory push to less risky and more transparent markets. Estimates vary but two years ago and the figure is still being bandied about, Deloitte, the professional services group, estimated that the total annual extra cost for the industry could hit €13bn, or 10 times its estimates for cleared swaps. This is because these OTC instruments, which according to International Swaps and Derivatives Association (ISDA), amount to a gross notional outstanding value of $86 trn out of a total $700 trn – are more complex and illiquid than their vanilla counterparts.
There are a variety of existing and new solutions in the works to help ease the pain. One that has been universally welcomed is the ISDA standard initial margin model (SIMM). Unlike the calculation of variation margin, which is based on day-to-day valuation changes that are often directly observable, initial margin configurations depend on the choice of model and the assumptions used.
The SIMM, which is still a work in progress, adopts a standard framework to calculate the amount of initial margin that needs to be exchanged, between counterparties, thereby reducing the potential for disputes. It also employs risk weights and correlation tables to specify the requirement as a percentage of the gross notional amount of the exposure in each asset class.
The trade group has also put time and resources into preparing for the necessary revisions to the ISDA credit support annex in each jurisdiction. They are developing a protocol to ensure the changes can be made to outstanding agreements as efficiently as possible. It will be a huge repapering exercise as CSAs have roughly 250 plus variable terms and they need to be standardised, according to David Maloy, COO of NetOTC. “At the moment the data is not consistent and documents need to be modified to support SIMM although it is not finished yet,” he adds.
Collateral management is another keystone. It has also undergone different machinations with transformation initially being seen as the way forward. Today the thinking is much more about optimisation, tri-party and new mutualised solutions.
The two major challenges are the calculations and movement of collateral and dispute management, according to David White, triResolve Product Marketing Executive, TriOptima, which is part of ICAP’s post-trade risk mitigation group. He notes that collateral management for many banks is a fragmented and highly manual process that tends to rely on multiple vendor and internal systems along with emails, phone calls and at times several people if a dispute arises over a margin call.
“The current infrastructure has not been built to handle the massive increase that we will see in margin calls and the number of counterparties that will be involved,” he adds. “Different systems and people focus on different parts of the same process and they do not talk to each other efficiently.”
“The current infrastructure has not been built to handle the massive increase that we will see in margin calls and the number of counterparties that will be involved,” he adds. “Different systems and people focus on different parts of the same process and they do not talk to each other efficiently.” – David White, triResolve Product Marketing Executive, TriOptima.
Automating the process has not been an easy nut to crack and one of the first attempts, Project Colin, fell apart in third quarter 2015. However, last year, a replacement was found in the form of MarginSphere2, an integrated end-to-end margin processing hub for non-cleared OTC derivatives that combines AcadiaSoft’s MarginSphere OTC derivative electronic messaging service with TriOptima’s triResolve OTC trade reconciliation service and the Margin Transit Utility (MTU) to be operated by the DTCC-Euroclear GlobalCollateral joint venture.
Currently, twenty-eight of the world’s largest banks are participating in industrywide testing of the service. “Most of the broker dealers are looking for centralised utilities and industry based solutions,” says Ted Leveroni, Chief Commercial Officer of DTCC-Euroclear GlobalCollateral, which was created in September 2014. “They could use internal solutions, but this would mean a lack of consistency, and data standards.
Leveroni also believes that these types of solutions are not only applicable to the movement but also the settlement of collateral where fails currently run at an industry average of 3%, according to a white paper – Implications of Settlement Fails – prepared for DTCC-Euroclear Global Collateral by PwC. The report, which canvassed collateral settlement specialists on the buy and sell side, as well as technology providers, custodians, and outsourcing providers, predicted that by 2020, the average annual operational cost of remedying these fails for survey respondents could rise 407% to $3.6 m for each buy-side firm and 377% to $2.4 m for each sell-side firm.
Leveroni notes that miscommunication such as incomplete or incorrect data being sent in messages between counterparties is one of the main underlying reasons for the fails. The problem is that the receiving counterpart may have insufficient time to identify and resolve before the settlement deadline, particularly if the movement is across countries, where different practices and cut-off times operate.
Although broker dealers could enhance internal processes it would require considerable co-ordination, and automation. A much simpler and cost effective method can be found in utilities that offer standard messaging platforms that automate standard settlement instructions and account information through a global database.
Mutualised solutions though are not the only ones on the table. The tried and tested tri-party arrangements are also seen as part of the mix. “Firms do not want to re-invent the wheel and want to take the least painful route,” says Mark Higgins, managing director, BNY Mellon Markets. “If you are a big bank that needs to optimise your collateral and allocated a range of assets, a tri-party platform makes sense. It is well understood and there are already four well established platforms in Europe. The benefit is that the client can work together with the tri party agent, extending out from how they typically use them today for repo or securities lending collateral. It is an extension of what they are already familiar with.”
In Europe, the principal tri-party agents are Clearstream Luxembourg, Euroclear, Bank of New York Mellon and JP Morgan and SIS while in the US the latter two dominate the market. The agent, which typically acts as go between the client and clearinghouse, not only allocates collateral to different accounts from a pool but also provides marking to market, re-pricing and delivery services.
However, Higgins does note that tri-party may not be for everyone. “If you are in the 2017/2018 wave and are used to providing cash or just a handful of securities, then tri-party across a platform like this may not be for you and the better option would be to use our MarginDirect service, supporting cash, bonds and equity pledged within a custody based framework, which is operationally similar to the process used when posting variation margin today.
In fact, Fergus Pery, Director and Product Head for OpenCollateral, part of Citi’s Investor Services, notes that he is seeing an increasing number of banks who are planning to use cash and not securities for initial margin. “It is often a case of smaller affiliates that may not have access to the necessary inventory or are just not part of the tri-party world. They are looking for alternative solutions to bridge the gap, such as segregated third party custody accounts combined with the necessary collateral operational functions”.
