Mohit Gupta of Cassini Systems outlines the ways in which our clients, and other in scope firms can find opportunity in the UMR delay.
Derivatives trading has undergone wide ranging changes in regulation since the global financial crisis. The requirement for posting margin on cleared and bilateral trades has been one of those changes; impacting the cost of trading directly, while aiming to reduce the counterparty credit risk and ensuring stability.
While the requirement for initial margin was initially only mandatory for trades cleared through a central clearing house, it has since also encompassed bilateral trades. Given the widespread scope of bilateral derivatives, BCBS/IOSCO proposed a five phase implementation towards mandatory posting of initial margin. As part of this, the last phase – Phase 5 – was to come into effect in September 2020. However, with the phase 4 approaching (commencing 1 September 2019), a widely expected delay was announced on 23rd July 2019. This added a new threshold and thereby introducing a 6th phase, which comes into effect in September 2021.
Those firms with over $750bn in Average Aggregate Notional Amount (AANA) will still be required to begin posting Initial Margin from 1 September 2019 (phase 4). Firms with 50 BN-749 BN notional exposure will now begin posting in 1 September 2020 (phase 5) and those with exposure between $8bn and $49bn will begin posting from September 2021 (phase 6). As before, firms with AANA under $8bn are exempt.
As aptly summarized in a statement from the Basel Committee below, the delay is meant to help counterparties prepare better from an implementation point of view.
“The Basel Committee and IOSCO have agreed to this extended timeline in the interest of supporting the smooth and orderly implementation of the margin requirements which is consistent and harmonised across their member jurisdictions and helps avoid market fragmentation that could otherwise ensue. The Basel Committee and IOSCO expect that covered entities will act diligently to comply with the requirements by this revised timeline and strongly encourage market participants to make all relevant arrangements on a timely basis”
Impact of delay
Before the delay was announced, ISDA estimated about 1,100 counterparties would come in scope in Sept 2020 once the threshold falls from $750bn to $8bn. With the delay now introducing a new phase with a $50bn threshold, the number of counterparties coming into scope in September 2020 will be significantly lower, due to the higher threshold. A study by ISDA estimates that the number of counterparties caught in Phase 5 will fall by 70% – with the remaining going in to the newly formed Phase 6. Further similar studies by regulators CFTC and FCA have this number at 77% and 66%, respectively. Suffice to say that the delay pushes a lot of counterparties from Phase 5 to Phase 6 given the higher threshold.
The opportunity and solution
What does this mean for firms with AANA under $50bn? BCBS/IOSCO intend the delay to provide more time for smaller and mid-size firms to prepare fully, especially in Europe where they are also required to perform back-testing. The temptation will be to simply put the Uncleared Margin Rules (UMR) and Standard Initial Margin Model (SIMM) project on hold for 12 months but that would be a mistake, as the delay is being allowed specifically to provide additional time to prepare for the upcoming requirements.
Ultimately, the delay is meant to help provide time to work diligently towards implementing a solution for the regulations. At Cassini Systems, we think this delay is an opportunity which can be used both by firms in Phase 5 and Phase 6 to appropriately get ready for the regulations in a holistic sense rather than just looking at uncleared margin.
The key question is this: how can a client act on this delay and benefit from it? A few ways in which we at Cassini are helping our clients are enumerated below.
Understanding your AANA
AANA stands for average aggregate notional amount. This is the metric which decides if the client falls in Phase 5 or Phase 6 or is totally out of scope. The exact method of calculating AANA depends on the jurisdiction as certain products might be excluded in one jurisdiction but included in another. Even though the officially reported AANA has to be calculated for certain specific days dependent on the jurisdiction, it is recommended to have an process to be able to monitor AANA exposure on an ongoing basis as this will help to get an idea of the phase of implementation the firm will be in and then act accordingly. For instance, if my current AANA is €100bn, I am most likely going to fall in Phase 5 unless something drastically changes and reduces the exposure.
Managing your AANA
Once the firm has a clear picture of its AANA, the next step is to see if there is any way one can optimize the portfolio to reduce the AANA. Reducing AANA should be of particular interest to firms who are on the cusp of the threshold (i.e. close to €50bn or €8bn) as reducing and managing AANA can help them flip to the next phase or out of scope completely.
Reduction in AANA can be achieved through following approaches:
Compression – It is not uncommon to see trading books which have trades back and forth for the same risk. This is usually the case when original trades were not taken off but replaced with equal and opposite risk trades. This extinguishes the risk but still counts towards notional exposure. Compressing portfolios both unilaterally and multi-laterally can be used reduce notional exposure keeping risk profile within constraints.
Strategic clearing – The premise of the regulation imposing margin for uncleared derivatives is to bring them in line with cleared derivatives which have a margin associated with them. Given margin is to be posted for both uncleared (if you breach the $50m posting threshold) and cleared derivatives it can often be preferable to use the clearing avenues. The margin requirement for cleared trades is based on a five-day Margin Period of Risk and so are generally less for the same trades than uncleared margin requirements which are based on a 10-day Margin Period of Risk. With the arrival of more clearing houses, the range of products which can be cleared has greatly increased and this offers more avenues to firms while still keeping liquidity in mind. A few examples are as follows:
Interest Rate Swaps and Inflation Swaps are liquid with multiple exchanges offering them as products. Voluntarily clearing trades on rates products that are not mandatorily cleared can offer synergies in reducing AANA exposure.
FX Options – Clearing FX options at exchanges rather than keeping them as bilateral can reduce the AANA exposure. Given options have higher leverage than spot transactions, clearing them offers a bigger ‘bang-for-buck’ in reducing AANA.
CDS (Credit Default Swap) – A traditional bilateral market like CDS has seen the share of clearing on the rise of late and this further supports the argument for clearing over bilateral.
Trading Style – While it might not be possible for everyone to change their trading style, there are ways for those who can adapt to look at reducing AANA by such methods. A few examples are as follows:
Swap Note Futures – Trading Swap Note Futures to mimic the exposure of a traditional swap is one way of reducing AANA
Interest Rate Futures – Trading Futures which mimic the swaps exposure (like EuroDollar Futures, ERIS futures) is another way to reduce AANA
FX forwards – Even though physically settled FX forwards are not under scope for margin posting, they still count towards AANA calculations. Using FX futures to mimic the exposure of physically settled FX forward is one way to reduce AANA
The impact of UMR on buy side firms can be significant in operational and collateral costs, and while on the surface the change to split phase 5 into two phases seems fairly benign by just moving the regulatory deadline out a year, it actually presents opportunities for both phase 5 and phase 6 firms.
Phase 5 firms can review their AANA levels and may be able to take some of the steps suggested above to get themselves into phase 6. This saves the cost of collateral for another year as well as allowing more time to be fully prepared.
For phase 6 firms there is more time to review and modify trading behaviour, as well as balancing counterparty agreements to maximise the $50m posting threshold, which can reduce or possibly eliminate the cost of UMR.
Importantly it also helps firms by allowing time to implement a holistic solution across all derivatives trading to reduce IM requirements, identify cost of carry, attribute costs to portfolios and trades and generally implement a full cost control process for collateral.