Ongoing financial regulation will continue to be on the agenda this year for many financial institutions – both buy and sell side. Lynn Strongin Dodds offers a quick regulatory roundup of some of the regulation the derivatives space is focused on in 2022 including: UMR, LIBOR, CSDR and SFDR.
Uncleared Margin Rule (UMR)
For the past six years, buy and sell-side firms have been grappling with the inner workings of the Uncleared Margin Rule (UMR) and 2022 will be no different. Last year, the regulation applied to any entity that traded non-cleared derivatives exceeding an average notional value of US$50 billion. This year the threshold drops to US$8 billion although the number of organisations increases exponentially.
According to the International Swaps and Derivatives Association (ISDA), about 314 medium-sized sell and buy-side firms started exchanging initial margin (IM) last September while almost double that number – 775 – will be at the phase 6 starting gate on 21 September 2022. The difference is that many will be smaller buy-side firms that have never exchanged initial margin before nor have the resources to overhaul their operational and legal infrastructures to comply.
They will not only have to calculate their Average Aggregate Notional Value (AANA) to determine whether they are in scope but also notify counterparties if they are. Moreover, they will have to ensure they are meeting the different requirements of G 20 countries such as the US, Japan and Canada that have implemented their own UMR versions.
One of the most challenging hurdles is the IM threshold calculations. There are two regulatory options – the ISDA Standard Initial Margin Model (SIMM™), which participants in phases1 to 4 have all used, and Grid – known as the schedule. The latter is the standard approach, a methodology where the margin is calculated as a percentage of the notional. To date, SIMM™) is the preferred choice for most firms because it can be used for a variety of portfolios across the industry.
“Ahead of the final phase of UMR coming into force, numerous firms will face the unpleasant reality that they do not have the technology to effectively manage margin requirements globally,” said Edel Brophy, head of Tax & Regulatory Compliance at Fenergo. For example, there will be a significant increase in UMR counterparties that will require a front-to-back review of the existing infrastructure to accommodate an uptick in the volume and complexity of business-as-usual processing. Firms scheduled to come into the fold in Phase 6 must now jumpstart their decision-making processes to identify and implement the proper technology required.”
Matt Stauffer, managing director, head of Institutional Trade Processing at DTCC, also believes firms will benefit from further automating the collateral management process. He notes that this will not only help in-scope organisations to comply with the Phase 6 mandate but also enable them to use their available collateral more effectively, which should improve capital and liquidity management.
London Interbank Offered Rate (Libor)
As 2021 came to a close, the chapter on the London Interbank Offered Rate (Libor), also ended after 45 years. The lending rate can no longer be used as the reference rate in any new derivatives contracts, loans and credit card offers.
The transition has been a huge undertaking for regulators, banks and companies since the Financial Conduct Authority (FCA) set out its blueprint in 2017. The bulk of volumes of new privately negotiated swaps deals are now in the new so-called risk-free rates. These include UK Sterling Overnight Index Average (Sonia), the US’ Secured Overnight Financing Rate, (Sor), Euro Short-Term Rate (Estr), Swiss Average Rate Overnight (Saron) and Tokyo Overnight Average Rate (Tonar).
There have been though a few stragglers which UK and US regulators have made allowances for. The FCA, for example, introduced synthetic versions – Sonia plus a fixed spread – for six sterling and yen Libor rates for an extra year while the US Federal Reserve is permitting five-dollar Libor rates to continue for 18 months until June 2023 for existing but not new contracts. The aim is to ease any potential disruption and allow these laggards to catch up.
Philip Junod, senior director, TriReduce and TriBalance business management at OSTTRA, said that the transition away from Libor had presented significant operational challenges for the many banks, swap dealers, hedge funds and asset managers who were trying to identify ways to convert their Libor-linked derivatives trades in each jurisdiction. He noted that a bilateral approach to portfolio was helping market participants to reduce Libor switchover risk, optimise capital, and enhance operational efficiency ahead of the December deadline.
Looking ahead, all eyes will be on the impact that the growing popularity in the US of Credit Sensitive Rates (CSRs) such as Bloomberg’s BSBY and American Financial Exchange’s (AFX) Ameribor will have. The US market has been more welcoming to CSRs, given their Libor-like qualities while that is not the case in the UK where the regulators have been promoting Sonia because it is well established and different from the scandal plagued Libor.
The message from US regulators is confusing. Sofr is brand new although officially endorsed by the US Alternative Reference Rates Committee (ARRC). That did not stop Federal Reserve Vice Chair for Supervision Randal Quarles stating last year that, a bank can choose any rate it “determines to be appropriate for its funding model and customer needs” as long as it does the extra work needed to satisfy regulators on their decision-making.
He added, “If market participants do use a rate other than Sofr, they should ensure that they understand how their chosen reference rate is constructed, that they are aware of any fragilities associated with that rate, and — most importantly — that they use strong fallback provisions.”
The Central Securities Depositories Regulation (CSDR)
There have been many twists and turns in the long running CSDR saga. Introduced in 2014, its aim was to harmonise settlement cycles in Europeand reduce settlement failures, providing a set of common requirements for Central Securities Depositories (CSDs) across the bloc. However, following an industry backlash, regulators moved the goalposts late last year which will see penalties for failed trades and subsequent reporting of those be implemented on 1 February 2022, while Mandatory Buy-ins (MBIs) will be delayed, potentially for two-to-three years.
Pablo Portugal, managing director of Advocacy at the Association for Financial Markets in Europe (AFME), summed it up best for the alliance of 14 trade groups who expressed their concern (AFME welcomes postponement of Mandatory Buy-Ins under CSDR | AFME ). He said, “The mandatory buy-in rules have been widely acknowledged as being flawed and disproportionate. Their impact would lead to wider spreads and less liquidity, meaning more expensive and less efficient capital markets for Europe’s issuers and investors.”
Daniel Carpenter, Head of Regulation at Meritsoft, a Cognizant Company, said, “While mandatory buy-ins have been postponed, implementation of the CSDR penalty regime is set to impose significant additional costs on banks’ operations from February. While the penalties won’t apply for trades failing to settle in non-EEA jurisdictions, the GameStop incident at the start of 2021 served to highlight the impact of settlement fails across the global markets.”
He adds, “the focus now on reducing fails to minimise the impact of fines, systems and processes must be put in place to enable firms to fully understand their settlement fails workflows. It’s crucial that global custodian banks can provide granular levels of data, daily, to allow tracking and validation of CSD fine feeds. All the relevant data must be available digitally, and accessible centrally, to enable in-depth analysis of where trades are failing and why. Only then can market participants take action to reduce their incidence of fails and make informed decisions about which counterparty relationships are more, or less, profitable.”
Carpenter believes that once these solutions are in place, new technologies such as artificial intelligence (AI) will increasingly be used to predict the likelihood of future fails as businesses look beyond the regulatory imperative to achieve ever-greater efficiencies and cost optimisation across their operations.
Sustainable Finance Disclosure Regulation (SFDR)
In March 2021, the new Sustainable Finance Disclosure Regulation (SFDR) made its debut in the European Union. Asset managers are now required to categorise their funds into different categories of sustainability. While Article 8 products are classified as actively promoting environmental or social characteristics, those under Article 9 have sustainable investment as their objective. Article 6 funds do not have an Environmental, Social and Governance (ESG) focus but must either integrate ESG into their investment decision making process or explain why sustainability risk is not relevant.
Although derivatives do not fall under SFDR, Sustainability-linked Derivatives (SLDs) is one of the fastest growing areas. There are also credit-default-swap indexes, exchange-traded derivatives on listed ESG-related equity indexes and emissions-trading derivatives.
One of the biggest challenges is ensuring that the documentation for their ESG products accurately captures any Key Performance Indicators (KPIs) against which ESG targets are measured. KPIs are used in sustainability-linked derivatives to monitor compliance with the relevant ESG criterion – for example, a KPI might be the amount of greenhouse gas emitted by a counterparty over a defined period of time or a percentage of a counterparty’s energy that is produced by sustainable sources.
To this end, last year, ISDA published a new paper entitled “Sustainability-linked Derivatives KPI Guidelines“. to educate market participants about sustainability-linked derivatives as well as establish a framework of best practices. The paper also includes a summary of the current ESG derivatives market, noting that most transactions are between financial institutions and non-financial institutions. However, for many of the other variants of ESG derivatives, there are no common standards.
Scott O’Maila, ISDA CEO discussed standards in a recent speech, “Since the first sustainability-linked derivative was executed in 2019, these products have emerged rapidly, allowing firms to embed a sustainability-linked cashflow using key performance indicators (KPIs) that monitor compliance with ESG targets. This is a market with real potential, but the transactions and the KPIs they use are very bespoke and customised to the needs of the counterparties,” he said.
He added, “The lack of standardisation in KPIs makes it difficult to accurately and consistently measure performance across different products and will ultimately prevent the scaling of the market. In response, ISDA has developed a set of KPI guidelines for sustainability-linked derivatives, with the aim of boosting the transparency and credibility of these instruments. Our aim is to promote widespread adherence to KPIs that are specific, verifiable and transparent.”
O’Mailia noted, “This is still a niche and nascent market, but experience has shown that standards and best practice are critical in promoting greater use of new products and building liquidity. Sustainability-linked derivatives may be an important way for many companies to meet their climate and development goals, so we hope market participants will review the guidance and adopt it for new transactions.”