As we hit the deadline for Phase 5 of the Uncleared Margin Rules (UMR), the industry has only one more year of preparation ahead of the final deadline impacting Phase 6 firms. Meanwhile, this set of new rules, among other regulatory changes, has transformed the collateral management space with the entrance of new industry solutions, multiple technological alliances and services launched to assist firms with compliance. As we enter the final sprint for UMR, DerivSource looks ahead at the big challenges collateral managers face now and what opportunities lie ahead to continue the evolution of this changing space.
Picking partners who can help with ‘now’ and ‘later’ margin needs
Mark Higgins, Product Manager, EMEA / APAC Product Development, BNY Mellon Markets
Current challenges addressed with room to improve
In recent years, we have seen large and small firms alike grapple with regulatory compliance relating to the use of collateral for OTC derivatives. As we have seen the migration toward mandatory central clearing, we have also seen greater demand for variation and initial margin (IM/VM), not only in the cleared space but also in the non-cleared OTC market.
We think collateral managers at firms of any scale will encounter the same fundamental challenge: to comply with UMR they are going to need to enhance the efficiency of both their operations and their funding. The demand for cash collateral as VM in both the cleared and non-cleared business remains strong, but the demand for non-cash collateral as IM is only increasing with each new phase of UMR.
Perhaps it is more important right now to be compliant with the regulations and then develop those operational and funding efficiencies over time. We have found that evolution seems to make more sense for our clients when they turn to us to act as their margin manager.
While a client does not have to address the entire UMR challenge immediately, we think it is important that they select a service provider with a proven history of evolution and a range of collateral segregation services, from providing individual compliance solutions to offering a comprehensive collateral administration service.
Leveraging standards and commonalities
Over the past few years, we at BNY Mellon – and the collateral management sector at large – have built out our UMR capabilities to manage the collateral volumes we expected to be sourced and posted in Phases 5 and 6.
Among those changes, we have adopted a fixed form Account Control Agreement based on ISDA-style elections rather than negotiated points. It helped us and our clients focus on what was possible rather than trying to define bespoke terms and allows clients to customize collateral eligibility based on a list of standardized options rather than asking for ad hoc arrangements. This has dramatically speeded up the onboarding process.
I think this is just one example of the benefits that can be realized when the industry is willing to adopt a common approach. There are other common processing standards that we welcome and will continue to explore for adoption over the next few years, alongside other enhancements like our electronic collateral schedule manager RULE, which has reduced the previously days or weeks long collateral negotiation process to a matter of hours.
Next steps = pre-trade analysis and margin optimisation
BNY Mellon has applied margin optimisation logic at the heart of triparty collateral management for many years. In practice, this has meant giving clients the tools to determine the most efficient assets to pledge in terms of applicable haircuts, cheapest to deliver, and other factors.
The next step for us and our clients will be to consider the ‘what if / pre-trade’ approach to best selection. If a firm considers what the trade means before it happens, then the margin cost can and should be factored in.
Practically speaking, this means determining whether an asset being considered for use as collateral could potentially have more ROE/ROA value being deployed for some other purpose. This is not a new concept for some of the larger banks in the market, but we believe it will become a more desirable capability across the buy-side in the years ahead. We are close to providing this functionality to buy-side clients, alongside the capability to independently verify dealer-issued margin calls. We should have something to announce on this front in the next few months.
Central clearing is an attractive option for optimization, cost management and efficiency
Ricky Maloney, Head of Buy Side Sales – Fixed Income, Funding and Financing, Eurex
The fifth phase of UMR sees broader inclusion of buy-side firms, which to date have remained relatively unscathed, given the previous Average Aggregate Notional Amount (AANA) levels. No client conversation this year is complete without reference to IBOR reform or UMR, two very important topics that are both resource-intensive. The operational set up required to achieve UMR compliance is complex, to say the least, whereas a cleared model provides advantages over a bilateral derivatives model that are well known and may shift more derivatives trades down the centrally cleared route.
There are a few noteworthy advantages to central clearing as they pertain to collateral management. For example, clients can trade or close a position out with an open panel rather than the bilateral counterpart with whom the original swap was executed. There are also significant margin reduction opportunities to be found in terms of cross margining at Eurex. Clients have seen some very impressive margin savings through combining inflation, IRS and listed derivatives into a single account. Furthermore, in funding these derivative positions, it is crucial to ensure the best possible terms are achieved in order to keep financing cost slippage to a minimum. Eurex’s multi-asset model is well known for its repo component, within which we see clients place and receive cash at preferential rates on a daily basis.
With respect to FX, we are observing an increased demand for cleared FX products, both physical and cash settled. Market participants are seeking out alternative solutions to mitigate the impact of UMR, including the clearing of FX NDFs, or moving to FX Futures to minimise margin costs and reduce exposures with respect to a firms AANA.
In addition, banks now face ever increasing pressure from capital costs. By clearing longer dated products such as cross currency swaps, firms can significantly reduce the burden of CVA and RWA charges. Clearing participants also profit from guaranteed daily net settlement through CLSClearedFX, which provides significant liquidity and funding benefits.
For many clients, particularly real money, this is a fundamental change to the way they conduct their derivatives business, the post trade obligations of UMR are significant and when compared to a cleared model, perhaps sub optimal. From an efficiency and cost perspective, the optimisation opportunities within a cleared environment are far and above that of the non-cleared environment, and we encourage clients who might like some guidance to contact us at their earliest opportunity.
Strides made since the start of UMR but race is still on with complexities to be tackled
Craig Bisson, Partner, Simmons & Simmons
There was an audible sigh of relief when, at the height of the pandemic, regulators agreed a one-year deferral to the final phase of regulatory IM. The new “Phase 6” IM requirements for uncleared trades apply from September 2022. ISDA has calculated that this will capture c. 775 entities and more than 5,400 counterparty relationships, presenting a real challenge to the industry.
The good news is that we’ve already moved through phases 1 – 5, and learned the lessons. When Simmons & Simmons advised the first buy-side firm subject to regulatory IM (a hedge fund caught by Phase 3), the documentation was still new and based on interbank terms – needing work to make them effective for the buy-side. Since then, the documentation has improved and the number of negotiable items (and how best to tackle them) has reduced.
But running a successful regulatory IM project is still a heavy lift, including for Ops and Risk as well as Legal (e.g. is the client/manager able to calculate SIMM?). It also takes time. Firms subject to Phase 6 should grasp the nettle now rather than leaving it until next year, particularly given custodian cut-offs (which can be several months ahead of the regulatory deadline).
There’s an inherent complexity in two-way segregated IM and the documentation challenge alone is significant. The security-interest nature of the arrangements is new to many on the buy-side used to the relative simplicity of title transfer.
If you expect to exceed the AANA threshold for Phase 6 and the IM threshold of €50m (harder to calculate in a multi-manager arrangement), it’s important to notify counterparties and begin preparations.
A number of key initial decisions need to be made, including: (1) which custodian platform(s) to use for the posting leg (2) whether to use tri-party or third party custody structures (3) whether to calculate using ISDA SIMMTM or grid (4) will dealers post to Euroclear and if so how will you on-board as a buy-side firm, and (5) what assets will you post and receive?
Even if your funds/clients will be below the threshold, don’t forget that this is now an ongoing calculation. Calculation periods for subsequent years will see new entities fall within scope.
Some firms may use portfolio compression techniques or alternative strategies (e.g. central clearing) to try to avoid falling within the reg IM net. But for those firms that are caught – the race is on.
Investment in data analytics and forecasting now to better manage costs longer term
Liam Huxley, CEO and Founder, Cassini Systems
The next challenge for collateral managers is one that if addressed properly, also creates an opportunity. The changes in the derivatives market over recent years have created increased collateral demands across the board, and dynamic margining that reacts to market movements also creates operational risk. In addition, the increased demand for collateral in different trading portfolios increases the carry cost of trades and can lead to inefficient capital allocation. So, the challenge for collateral managers is how to put in place models that can project future collateral demands, optimise margin and collateral, and avoid collateral liquidity crunches. This can be achieved by implementing robust data analytics on top of the collateral workflow processes. The recent market volatility and sudden margin increases of 100%-200% have demonstrated the risk to a trading book that can occur from collateral demands.
By implementing solutions to provide visibility and forecasting tools, collateral managers can enable their firm to reduce margin levels and therefore collateral demands, forecast VM requirements, and project future collateral sufficiency. This operational risk management also presents an opportunity, because by putting these types of tools in, you can then also create a full collateral cost model which then leads to reduced operational costs and frees up cash and collateral assets. This brings collateral transparency and cost management into the full business flow and results in improved P&L through operational alpha.
It is important to address these areas now because the rolling out of UMR regulations will add additional collateral demand going forward, and at the same time these regulations are forcing firms to address collateral processes and implement new solutions. If the scope of these regulatory projects can be extended to address analytics and forecasting, then much larger long-term benefits can be created as part of the same overall initiative.
Next up – Focus on messaging, Inventory and liquidity management and legal data harvesting
Shaun Murray, Managing Director and CEO, Margin Reform
Collateral managers may sit in different parts of an organisation. Typically, it would have been someone who sat in margin or collateral operations. In the current environment, it could be treasury, managing the liquidity and funding positions, or the XVA/ALM desk controlling variation and initial margin via pricing and eligible collateral schedules, or someone concerned with centralised collateral optimisation across the different trading desks of an organisation.
Irrespective, all parts of an organisation need to be working cohesively to ensure that collateral management complexity is simplified. It could be focusing on automation, looking at settlement capability, or piecing together the jigsaw of pre-trade and post-trade. All firms want to enable best execution, rigorous and sustainable risk management, and post-trade excellence – both internally and externally – for requirements such as trade reporting and central clearing.
Each organisation will be looking to link these elements in an enhanced collateral ecosystem maybe by utilising a third-party collateral manager or beefing up their internal expertise and technology capability. In our opinion, there are three critical elements on which collateral managers should be focused.
- Collateral and settlement messaging
- Inventory and liquidity management
- Legal data harvesting
In almost every organisation, an improvement could be made and, in most cases, significant improvements would be possible. The new technologies and improved connectivity that the industry has worked on throughout the last decade are available to all. Taking advantage and investing wisely will enable firms to overcome new regulatory change, understand and proactively manage costs, and improve outdated or manual processes that reside in the operating model.
Collateral is no longer just a trend, it is here to stay, and firms should be thinking longer term about collateral management and all that it involves. It’s a multi-year investment affecting almost every part of an organisation, and the cost of doing nothing is now too great.