Ready or not, initial margin requirements are coming. And unless you’re compliant in time, you won’t be able to trade bilaterally.
That is why Cassini Systems has put together a 3-part informative series, solely focused on ISDA SIMM™ for buy-side firms.
Over the course of the next three weeks, Cassini Systems will shine a light on the complex world of Uncleared Margin Rules (UMRs). We will delve into what these regulations mean for your organisation as well as outlining some factors to think about as you start planning for implementation of UMRs and SIMM™.
We will also explore the steps needed to ensure you remain compliant, and more importantly, how you can minimise the impact of the additional collateral requirements on your liquidity and trading.
Part 1 of 3: Getting started.
The final phases of the BCBS / IOSCO’s uncleared margin rules — phase 4 and 5 — are kicking in as from 1 September 2019 and 2020. In the first of this three-part series, we take a look at what this means for your organisation and what you need to do to achieve compliance.
299 days, 13 hours and 15 minutes.
That’s how much time’s left, at the time of writing, before phase 4 of BCBS / IOSCO’s uncleared margin rules (UMR) kicks in (phase 5 will be kicking in a year later, in 2020).
Industry estimates are that it’ll take buy side firms about 9 to 12 months to implement the changes these new requirements will bring about. Yet, during a webinar on initial margin hosted by our friends at CloudMargin, only 4.5% of participants told us they had an implementation plan and budget in place*.
With this in mind, here’s a look at the main issues you’ll need to get to grips with to put your organisation on the road to compliance.
What’s changing in September 2019 and 2020?
BCBS / IOSCO’s uncleared margin rules require all firms with a notional swap exposure of over $8Bn to start posting two-way initial margin. These new requirements are being rolled out in phases, based on organisations’ notional amount of non-centrally cleared derivatives.
The first 3 phases — these affected organisations with notional exposure of more than €3 trillion, €2.25 trillion and €1.5 trillion respectively — have already been completed. As from 1 September 2019, initial margin requirements will roll out to organisations with an exposure of more than €0.75 trillion. And, crucially for the buy side, from 1 September 2020 they’ll start applying to organisations with exposures of over €8 billion.
So far, so good. But what does this mean in real terms?
Firstly, because you’ll have to start posting initial margin, bilateral OTC trading is about to get more expensive (spoiler alert: we’ll show you how you can keep trading as cost-effective as possible in Part 3).
Additionally, the “two-way margin” point is critical. As a buy-side firm you not only have to post initial margin. You also have to call it. And of course, there are strict rules around collateral segregation to take into consideration.
This means you’ll have to put new processes, new counterparty and custodial agreements, and new technology in place. If you’re in scope for September 2019 — or 2020 — and haven’t implemented these changes, you won’t be able to trade bilaterally.
Implementing uncleared initial margin – Three key areas you should be focusing on now:
Repapering, repapering and more repapering
Your counterparty agreements will need to be amended to include initial margin. And while you may have laid the groundwork when complying with BCBS / IOSCO’s variation margin rules, you shouldn’t underestimate the amount of work involved.
For starters, repapering will be a challenge simply in terms of volume. You may have to renegotiate hundreds or even thousands of CSAs (credit support annexes) to bring them in line with the new rules. Ernst and Young estimate that negotiating a bilateral legal agreement can take up to three months for one entity pair alone.
Workload aside, the new rules only apply to transactions executed after September 2019 (or 2020, if you’re caught by phase 5). This means you’ll need to decide whether you’re better off including pre-2019 or 2020 swaps into your new agreements or keeping them separate. And this will affect your repapering and negotiation strategy.
It goes without saying that whichever choice you make will create additional complexities. Choosing to include both pre and post deadline swaps into a new agreement could mean losing more favourable terms on your old swaps. On the other hand, you’ll need to build new workflows to manage pre and post deadline swaps separately.
Custodians and risk management
You can use cash and non-cash assets to satisfy initial margin. But if you’re planning to use cash, you’ll need to involve custodians.
According to the rules, you must have separate custody agreements for collateral you’re posting and collateral you’re calling. This means you need to get multiple agreements set up, which has its particular set of challenges, including:
- Initial KYC, which can be time-intensive
- Your counterparties may choose to work with different custodians, in which case you’ll need to take steps to link up
- Custodians’ account setup deadlines may come earlier in the year, which means you’ll need to complete your agreement ahead of time in order to make the 1 September UMR deadline
Calculating initial margin
According to BCBS / IOSCO’s rules, initial margin must be consistent with a one-tailed 99% confidence interval over a 10-day horizon, based on historical data that incorporates a period of significant stress.
To help the industry meet this requirement, ISDA has created the Standard Initial Margin Model or SIMMTM, which has regulatory approval and is, by design, quick to calculate, easy to replicate and easy to understand. The model requires a defined set of risk sensitivities at a trade or portfolio level, then aggregates them and applies correlation, concentration, diversification factors to derive the initial margin requirement you need to post or call.
ISDA SIMMTMis a great initiative and has huge benefits. It’s accurate. It lessens the chance of disputes due to methodology differences. And it’s easier to get regulatory approval.
Of course the risk based calculations require robust curve building and market data in order to calculate sensitivities correctly. In another poll held during the CloudMargin webinar, 47.7% of respondents told us they either haven’t decided or don’t yet know how they’re going to go about this*.
Time to start preparing
Ready or not, initial margin requirements are coming. And unless you’re compliant in time, you won’t be able to trade bilaterally, which could mean huge risk exposures.
Here we’ve outlined some factors to think about as you start planning for implementation of UMRs and SIMM. But how do you make sure you’re compliant? And, more importantly, how do you minimise the impact of the additional collateral requirements on your liquidity and trading?
We’ll look at these challenges in parts 2 & 3 of this series. You can read ‘Part 2 of 3: The road to compliance’ now.
These ISDA resources are a great starting point, too: