As market participants come to terms with the latest batch of uncleared margin rules (UMR), Phil Hermon, Executive Director, FX Products at CME Group, unpicks the challenges that numerous buy-side firms caught in phase 5 will have to overcome.
Q. What does UMR Phase 5 mean for the FX market and who does it impact?
A. Although phases one through to four (which began in September of 2016) hit the largest dealers first before then hitting the largest hedge funds, phases five and six are expected to be the most significant. This is due to the sheer number of funds and institutional investors potentially caught by the average aggregated notional amount (AANA) calculation, with the threshold falling to €/$8 billion in September 2022.
However, it is important to put things in perspective when it comes to the impact of the UMR on FX markets. Under the rules, the initial margin requirements for those pulled into the requirements exempts deliverable forwards and FX swaps ‒ which leaves a focus on products such as non-deliverable forwards (NDFs) and FX options. Of all these, FX options stand out as a potential source of higher margin requirements – both because of how the ISDA standard initial margin model (SIMM) works and because the products most used for a delta hedge (forwards and spot) are excluded from the regulatory requirement. Partly as a result of UMR pressures, we have seen an increase of 33.8% from end user customers in our listed FX options.
Q. Which customer type do you feel may be most impacted by Phase 5 of UMR and what are the specific challenges and actions for these entities?
A.Phase five, which came into force earlier this month, has been estimated to impact hundreds of entities. However, as with any regulation, some firms are affected more than others, and it may be the real money accounts who experience more challenges as a result of UMR. A combination of a lack of familiarity in managing and posting initial margin, not being comfortable with using a prime broker due to the counterparty credit concerns associated with consolidating risk with one bilateral counterparty, and the typically directional nature of trading could all result in increased costs and a need to adapt trading behaviours.
Once caught by UMR, there are several actions each entity will need to take. These include the following:
- One-off/tactical items: New Credit Support Annex (CSA) with each bilateral counterpart, setting up a custodial account for the two-way posting of initial margin (IM), and implementing the ISDA SIMM model to enable IM calculation.
- Ongoing tasks requiring resourcing: Daily calculation, reconciliation, and dispute resolution of IM requirements. Funding, posting, and optimising any IM over and above the minimum transfer amount (MTA).
On the other side of the equation, hedge funds are arguably well positioned to help manage and optimise the ongoing impacts of UMR. They are well accustomed to posting an independent amount (IA) or IM on their positions and typically use a prime broker (PB) ‒ who can not only net all of their positions together but who may also be able to utilise IM models that enable margin optimisation techniques such as consolidating FX FWDs forwards back alongside FX options.
Q. Is the Initial Margin in centrally cleared products different to the IM requirements of UMR?
A. The FX market has two main mechanisms to access central clearing – OTC clearing and using Listed FX products, both of which serve to remove the gross notional of trades from the AANA calculation, whilst also netting all of the products against a CCP and allowing the CCP margin regime to be utilised instead of ISDA SIMM. The combination of the netting impacts as well as the IM model differences can result in very different IM requirements between cleared and bilateral. For example, recent analysis by OpenGamma demonstrated that CME listed FX Options can be up to 86% more efficient compared to holding those positions bilaterally with the IM then calculated by ISDA SIMM.
Q. Do you expect phase 5 and 6 of UMR to create a lasting change in how FX is traded?
A. Whilst the broader strategic impacts of UMR on “front-end” trading behaviours are currently not totally clear, we have already seen some trends within clearing in the FX market which may in part be driven by UMR pressures. An increasing number of customers are embracing listed FX futures and options (the number of large open interest positions held by customers in CME FX futures is up +14% year on year and we have seen some significant recent open interest records in both AUD and CAD listed FX Options), gaining diversified liquidity and capital efficiencies in the process.
Of all the market participants, real money accounts may face the greatest obstacles in dealing with the impacts of UMR over the coming months. A combination of a lack of familiarity in managing and posting IM, the counterparty credit concerns with consolidating risk with one bilateral counterparty as a PB, and the typically directional nature of trading could all result in increased costs and a need to adapt trading behaviours for the long term.
These potential challenges may drive the increased usage of cleared FX products, in particular FX options and emerging market (NDF) currency pairs, as this will not only mitigate the human capital cost of the daily processes required under UMR but will also help in optimising the funding cost of IM by having everything netted against a highly regulated CCP.
