Phase 5 of the uncleared margin rules (UMR) is due to come into effect in September 2020. In a DerivSource Q&A, Chetan Joshi, founding partner of boutique practitioner-led consultancy Margin Reform, discusses the steps Phase 5 firms need to take to prepare for margin reform and some of the main challenges they may face. Listen to related podcast.
As the Phase 5 deadline draws nearer, the industry has done a lot of advocacy work with regulators globally, explaining some of the challenges for Phase 5 firms in 2020. For example, there is advocacy around removing physically settled FX Forwards, increasing the threshold for Phase 5 from $8 billion to $100 billion. The industry has also sought clarification around what firms need to do if they are never going to breach the $50 million threshold. BCBS IOSCO provided a statement on the 5thMarch in response.
Recent statement from BCBS-IOSCO
At Margin Reform we believe the recent statement and press release from BCBS-IOSCO providing leniency towards documentation requirements is not the type of change that some were expecting. The point around covered entities acting diligently needs to be deciphered by each firm. If they are not going to “paper up” they need to ensure they remain regulatory compliant . This means having a process to calculate the SIMM, to monitor the group threshold, and in the event of a ‘diligence’ breach, having a clear and practical way to get the required arrangements in place. While this may alleviate the pressure of repapering, it also moves the focus onto how you stay compliant in other areas.
Some people have been waiting for the results of the advocacy and are hoping that the threshold will change from $8 billion to $100 billion, so that they will not get injected into this regulation. Some firms have started already, because there are multiple aspects to solve, which need to be worked on in parallel. It is very important for firms to start now and find out the key quick questions that they need to solve for with regards to this compliance.
Key elements of a UMR compliance plan
After going through the regulation over the last four years with a Phase 1 bank, there are a number of aspects that firms need to solve for. The first is around self-disclosure. Is the firm a Phase 4 or Phase 5 firm? Who is in scope? People tend to rush into this but they should actually take a step back and consider if they need to carry on trading with the same relationships. Client engagement and speaking to clients at an early stage is critical. Firms should think about how they talk to clients. Is it via phone or email? Do they use different forms of electronic communication with them? It is very important to figure out that strategy.
The next bit is around rule distillation, working out which rules apply and how to break those rules down line by line and allocate them to different functions within the organization, and making sure that people understand what they need to do, and they are interpreting the rules as a collective group. While it doesn’t sound exciting, this is the piece that will prevent firms from getting a regulatory fine. When the EMIR Refit goes live in 2020, firms will also have to get their models approved, which will be a big challenge for the industry.
Once firms have got the scope of clients, and know the rules that apply, they need to look at legal documentation. They need to have either a service provider or an internal team that can re-paper all these agreements in a timely manner. One of the biggest challenges has been understanding where all these documents are. Are they stuck with a client or in-house? If in-house, is it with the credit or legal department? It has been difficult to track using email and spreadsheets, but there are vendors providing online solutions to mitigate those issues.
Then moving into the custodial side of things and the onboarding of custodians, firms need to work out which custodian they are going to use, and which type of model. There are a lot of Know Your Customer (KYC), and Anti-Money Laundering (AML) steps firms need to go through, which take a lot of time. The industry underestimated that timeframe during Phase 1, and a number of relationships weren’t able to trade because the custodian accounts weren’t set up in time. The custodian plays such a big role now in the compliance program. Having that onboarding done in time with the right custodian, with the right model is essential. They also need to understand the differences between third-party and tri-party, and have a strategy around that.
“There are a lot of Know Your Customer (KYC), and Anti-Money Laundering (AML) steps firms need to go through, which take a lot of time. The industry underestimated that timeframe during Phase 1, and a number of relationships weren’t able to trade because the custodian accounts weren’t set up in time.”
Technology is the enabler that will help firms accelerate their compliance program. Legacy technology systems were not built to handle the IM models that deal with concentration and wrong-way risk. So, the technology stack needs to be enhanced to be able to comply with these regulations. There are multiple rules that require technology solutions, so having the right technology partner that can help build out the right capabilities is really important, and firms need to determine how they are going to interact with the ecosystem that the buy side and sell side will be connected to.
They also need to build up their operational teams and make sure they have the right people with the right skill sets to perform the new tasks that this regulation creates. How are they going to optimize their collateral? How do they post the right piece of collateral when this collateral is segregated under IM rules? Do they have the right selection transformation services around that? The way firms reconcile their IM model is by looking at risk sensitivities. Do they have people that can understand risk sensitivities and reconcile and match those?
One of the biggest challenges involves understanding which model to use. Will it be the ISDA SIMM model, the regulatory schedule, or a mixture of the two? Last year, Mizuho Capital was fined $900,000 for not having the right governance and the right controls around their IM model. The regulators are keen to make sure firms understand their model, know how to control it, and have the right lines of defense around the model.
With regards to collateral, firms need to post it to a custodian, and it has to be segregated. There is a misconception in the industry that firms can just post loads of cash into a custodian. Firms have a 20% concentration limit on cash, so it is vital to read the rules and work out what type of collateral they can source, and what type of collateral they can post. There are different options where firms could have collateral which is ineligible and transform that into eligible collateral. They need to have the right partner to help upgrade or downgrade their assets, which will reduce costs and allow them to post more efficiently to their custodians.
Take advantage of the ecosystem that has developed
This regulation may seem overwhelming, with 1100 counterparties in scope, 10,000 relationships, and 19,000 segregated accounts. It is quite frightening for someone that has never looked at this before. But there are a number of firms out there that can educate people on what they need to do, look at what their real issues are and help them mitigate those, and allow them to transform with the speed they want.
There are now a number of accelerators, assets and tools in the market that can help firms get compliant very quickly. At the beginning of Phase 1, there weren’t many solutions and people had to build everything from scratch. Now there is an ecosystem that can provide firms with a number of solutions, a one-stop shop. Firms should start talking to people now, even if 2020 seems far away, and start thinking about building out a plan and finding the right advisors and the right service providers.
