Despite the recently announced delay to upcoming deadlines for the last two implementation phases (5 and 6) for the Uncleared Margin Rules (UMR) due to the COVID-19 pandemic, firms still face a raft of operational, legal and documentation changes required to support the overhaul of collateral management practices necessary for compliance. This added time, however, presents firms with an opportunity to incorporate margin optimization techniques in tandem with regulatory change management programs. Kashyap Sheth, of IHS Markit, shares his quick view on the pre and post-trade margin optimization techniques firms can adopt now. Comments originally shared during a recent UMR webinar – “UMR Compliance and optimization for upcoming phases 5 and 6 and beyond)”.
Scenario
The Basel Committee on Banking Supervision (BCBS) and the International Organization of Securities Commissions (IOSCO) both recently agreed to extend the existing deadline by one year for Phases 5 and 6 of the Uncleared Margin Rules (UMR) for non-cleared derivatives as a result of the disruption caused by the COVID-19 pandemic. Despite the challenges firms face with the current market conditions and the complexities of compliance from an operational, legal and documentation perspective, firms have the opportunity to review and implement margin optimization strategies as part of wider compliance change programmes. I believe once these Phase 5 and 6 firms start (if they haven’t already) undertaking change programmes, the importance of regular assessment of the impact of these rules on bilateral trade strategies and the Initial Margin (IM) amount required will support greater plans to adopt optimisation techniques at both the pre and post-trade level.
Pre-trade Optimization
Pre- trade margin optimization will become a key component of the drive for greater efficiency and is a good starting point. There are a few ways to achieve this optimization.
Central clearing: Firstly, firms need to start looking at where they can push derivatives trades to be centrally cleared via a central counterparty (CCP) or clearinghouse as there are immediate margin efficiencies in central clearing compared to bilateral trading. For example, if you compare the Margin Period of Risk (MPOR) for bilateral trades (generally a ten-day period) to cleared trades (generally a period of seven days or even less), by design, bilateral margin amount will most likely be higher than the cleared margin amount which means central clearing will probably make more sense for firms if this is appropriate.
Dealer analysis: Secondly firms can look to identify the broker/dealer with the lowest IM impact. This would require a firm to have solutions and tools in place to perform ‘what if analysis’ to identify whether Dealer A or Dealer B has the lowest impact in terms of IM for either a new trade or a brand new strategy. Once a firm knows the IM impact, it can check the margin thresholds it will have against each dealer. Under UMR, firms have to post margin only if the amount is greater than $50 million threshold.
ISDA SIMM™ vs GRID: Finally, and focusing on IM calculation methodologies, a common view is that ISDA SIMM™is likely to give a lower IM compared to GRID or Schedule calculations. However, that is only so true so long as your portfolio has offsetting positions in which case netting and correlation is going to be applied and it makes sense. But for directional portfolios, GRID will still make sense as an IM calculation method.
In short, a firm can conduct what if analysis on its existing portfolios, run the different calculations and then identify which path forward is most efficient from a margin use perspective.
Post-trade Optimization
There are also margin efficiency strategies firms can adopt post trade including in the novation, trade compression and backloading processes.
Novation: A firm can novate its trade to dealers with the lowest IM impact similar to the pre-trade changes described previously which will help a firm optimise IM thresholds overall.
Compression: Trade compression is a process where a firm can place multiple offsetting derivatives positions with existing positions but still maintain the same risk profile of the portfolio while reducing the total gross notional. Now while this means a firm is reducing the gross notional amount, it is also reducing its Aggregate Average Notional Amount (AANA).
Backloading: Firms can simply move all legacy trades to clearing, where possible, which would reduce gross notional, the AANA and potentially the IM amount.
In summary, while the extended deadline is welcome and necessary for firms to prepare for UMR compliance despite the disruption caused by the current pandemic, firms should consider adopting margin optimization changes now and as part of wider compliance programs to ensure they make the most of their margin now in the long-term.
