The BCBS/IOSCO variation margin requirement deadline looms for market participants despite recent statements by various regulatory bodies. Helen Nicol, Global Product Director, Collateral Solutions at Lombard Risk, explains why firms, including buy-side institutions, should focus on system interoperability as they make the changes necessary to get legal documentation and operational processes in place.
Non-cleared margin requirements – where are we now?
Margining requirements for Over-the-Counter (OTC) derivatives under the Basel Committee for Banking Supervision and the International Organisation of Securities Commissions (BCBS/IOSCO) came into force for the largest market participants on September 1st, 2016. In preparation for this, the large dealers focused especially on the operational plumbing fixes that needed to be put in place, such as renegotiating credit support annexes (CSAs), with a particular focus on terms involving haircuts, eligible collateral, day one settlements, and how the negotiation process is going to take place between the buy side and sell side.
Smaller firms, including most on the buy side, had a six-month delay until March 1st, 2017 to get ready for the variation margin (VM) deadline, and have up to three more years before they face initial margin (IM) requirements. Recently IOSCO and some regulatory bodies, such as the European Supervisory Authorities (ESA), Financial Conduct Authority (FCA), and Federal Reserve have issued public statements acknowledging the high level of operational and legal changes needed to support the upcoming deadline for VM requirements. Despite this acknowledgement, the deadline remains March 1st for market participants and firms must not take their foot off the pedal.
Starting with documentation
Efforts to meet the VM requirement start with documentation and firms are busy renegotiating their CSAs. Some are using the ISDA Amend tool, a joint service provided by IHS Markit and the International Swaps and Derivatives Association (ISDA), which enables firms to amend their ISDA agreements and facilitates compliance with the new requirements under the Dodd-Frank Act and the European Market Infrastructure Regulation (EMIR). However, if firms don’t already have the underlying CSAs in place, they have a lot more work to do than just updating their agreements. They need to get segregated accounts set up, and have conversations with dealers, custodians, and tri-party agents around potentially new processes—all of which is very time consuming.
If firms don’t already have the underlying CSAs in place, they have a lot more work to do than just updating their agreements. They need to get segregated accounts set up, and have conversations with dealers, custodians, and tri-party agents around potentially new processes—all of which is very time consuming.
Various regulations, including Dodd-Frank, have specifications around the netting process. Pension funds need to look at how they are affected by these. Are they covered under bankruptcy laws, and therefore do they have the option for safe harbour, or would the banks be forced to look at stays? Under Canadian regulations, buy-side firms have to consider whether to use a gross or net calculation for both variation and initial margin. This leads to the various concepts of net, gross, gross-net, gross-gross, or net-net.
Focus on systems interoperability
Aside from legal issues and documentation agreements, firms also need to figure out how this will work from an operational perspective, through vendor or in-house platforms. If someone in Canada is doing a gross calculation, and their counterparty in Japan, for example, is making a net calculation, how do we look at the whole workflow, including the dispute process and the connectivity with those downstream systems? The legal documentation, and potentially the collateral management system may be in place, but this then has to work through the messaging systems, the custodians, the settlement systems, and so on.
Collateral and messaging system vendors and custodians are working together to jointly support their clients. Everything needs to work—end-to-end—from a STP perspective.
The buy side has more time than the sell side, but the sooner they start taking action, the better. It takes time, not just from an implementation perspective, but also from a testing point of view, to make sure all the links flow from both upstream and downstream systems. Some firms will see a huge increase in volumes and need to think about whether they are going to handle that with additional resources, or if they are going to look for more STP functionality to get the margin call issued. How does that then flow to the settlement engines and how do they receive the incoming messages back up?
Buy-side firms need to work out what they believe the volumes are going to be, how they want to handle them, and what their main focus is. How will minimum transfer amounts (MTAs) be handled? Particularly, when they have a number of asset managers and taking into consideration how they will monitor what they have where. Do they have something in place already? Or do they need to talk to a variety of different vendors?
From the sell-side perspective, many of our clients have been working on the implementation of the regulations for two and a half years. But now the buy side—particularly the larger firms—also need to take action. A spike in volumes has the potential to increase operational risk, so firms need to look at their own internal strategies and policies and work out what they think they need to do in order to mitigate risk.
There are many solutions available, whether firms choose a vendor platform, a cloud solution, or whether they are going to outsource. There is no right or wrong approach—firms will decide what suits them best in terms of their volumes and collateral management experience. If the firm has never dealt with collateral before, outsourcing may be the best option in the short term. Some may want something that’s fairly lightweight and quick to implement, while others will need a solution that offers more robust cross-asset capabilities.
Aspects of an ideal platform
When the deadline comes into force, buy-side firms will ideally have a platform that looks after legacy and regulatory agreements on a cross-jurisdictional basis. It should offer them the flexibility to issue and manage their daily processes manually if they only have a handful of agreements. But as the business grows, it should also offer more STP functionality—from agreement creation to the issuance of the negotiation, the control of the eligibility criteria, through to the settlement process, including messaging and ideally, disputes.
Firms also need to make sure that whatever platform they choose can keep pace from all aspects—settlements, messaging, collateral eligibility—with regulatory change in all asset classes. They need a platform that will grow with them, but also maintains everything from the operational, market and regulatory perspective.
Firms stand to gain control and flexibility
Beyond compliance, there are other benefits firms can realise, depending on the different asset classes they trade. Having everything in one place with direct links to those other messaging and settlement platforms gives them more control and enables them to manage their daily processes. They are aware of what assets they have where, and from a compliance perspective can track and report from them.
Participants on the buy and the sell side will benefit from increased flexibility in their own operations, and gain a better understanding of how the different types of counterparty—asset manager, dealer or corporate—work on a day-to-day basis. This will hopefully make the market work cohesively and develop more understanding for the differences between the buy side and sell side. While it is true that collateral is collateral, and the margin process is the same, there are always bespoke processes that go on in any organisation that mean different strategies and understandings need to be maintained in order to work successfully.