Initial Margin Phase 5 is almost here – is your firm ready?
Vice President - Legal
Monday 9 March 2020
At FinTrU we have helped our clients through the Variation Margin (VM) phases, and we have gained in-house experience working with the dealer group during Phase 1 of Initial Margin (IM) compliance. If you are newly in-scope for IM compliance, this article will give you a brief overview of the history, scoping and necessary calculations that you need to be familiar with.
Due to regional interpretation of the framework however, be warned that the Uncleared Margin Regulations (UMR) have not been implemented in a uniform manner across jurisdictions. Tara Kruse from ISDA recently noted that “Variants in product scope make cross-border margining complex and create an unlevel playing field across jurisdictions”, inevitably adding to the complexity of compliance.
Initial Margin is not a new concept, however the regulatory collateral posting necessitated by UMR poses a fresh challenge to a vast number of market participants who were not involved in the previous phases (see Table 1 below).
Table 1: Regulatory VM and IM phase in Schedule for Europe and USA
It is therefore vitally important to understand if you are in-scope for the final phases of implementation over the next 2 years. Whilst some parties have already started to consider compliance, these are typically entities brought in-scope by previous phases. Therefore, they have experience of the concepts, calculations and requirements under the applicable regulations.
From a practical perspective, VM was a numbers game – it impacted a large proportion of market participants and predominantly became an amendment exercise to pre-existing collateral documentation (albeit this is discounting the smaller population of more complex relationships that were remediated). IM will be vastly different; the compliance process is more complex and will result in a matrix of new documents being executed across relationships, the dynamic of which will hinge on IM counterparty custodial appointments.
The 2008/9 financial crisis saw a wave of regulatory reform which sought to bolster market stability, reducing the likelihood of further bailouts going forward. What we are mostly concerned with here is the Final Framework on Margin Requirements for Non-Centrally Cleared Derivatives[i] and subsequent regulation, commonly known as the uncleared margin rules (UMR). These rules have imposed margin posting requirements on market participants using OTC derivatives since 2016, with the requirements being phased in gradually over the last few years. Since the mandate to exchange IM on uncleared derivatives began the phase-in process, market participants, predominately from the sell-side, have been working hard updating OTC derivative contracts, restructuring operational systems, identifying middleware providers (where necessary) and engaging in custodial services.
Are you in-scope - AANA
With this in mind and given the additional burden IM compliance will put on firms and their trading capabilities, it is important to understand if, and when, you are in-scope for compliance. Following the welcome announcement in July last year by the Basel Committee on Banking Supervision (BCBS) and the International Organization of Securities Commissions (IOSCO), we now have two final phases for IM compliance[ii].
A party's go-live date is dependent on the aggregate average notional amount (AANA) of their in-scope derivatives portfolio[iii] during a specified period. Those with an AANA of at least €/$50bn fall into Phase 5 go-live by September this year, with Phase 6 following quickly in 2021 for those with an AANA above €/$8bn, yet less than €/$50bn. A firms AANA is will be the value calculated daily in the US and monthly in the EU, during March, April and May of 2020 for Phase 5, and March, April and May 2021 for Phase 6.
Firms who predominantly trade FX swaps and forwards will be in an unfortunate position when it comes to scope. Whilst these products are out of scope for IM margin posting (i.e. the calculation of the actual amount of IM a counterparty should provide will not include these products), they remain included in a firm’s in-scope derivatives portfolio for the purposes of their AANA calculation. ISDA lobbied on behalf of its members[iv] against this, however the BCBS/IOSCO have chosen not to exclude FX swaps and forwards from the AANA calculations, putting a seemingly unnecessary burden on those impacted by this decision.
What is IM and why is it deemed to be important for market stability?
In simple terms it is the upfront collateral, based on future risk of market volatility, provided by a party ahead of trading. The amount itself is a value above the mark-to-market exposure which is meant to represent any volatility between the time when exposure is calculated on a trade, and the time collateral is liquidated or transferred to the relevant party[v]. This value is meant to provide a buffer to unexpected risk, be that counterparty, operational or transactional.
IM thereby promotes stability, as it aims to reduce systemic risk by protecting the respective parties from exposure that could potentially arise from changes in the mark-to-market value of the trade[vi] and in particular, sudden changes. This covers the time it takes to close out and replace the position in a default scenario. The non-defaulting party then seeks recourse from the IM collateral posted, to cover any loss, thus preventing a domino effect across the market caused by un-recouped loss – such was the case in 2008/9.
BCBS-IOSCO guidelines state that your IM calculation “should reflect an extreme but plausible estimate of an increase in the value of the instrument that is consistent with a one-tailed 99% confidence interval over a 10-day horizon, based on historical data that incorporates a period of significant financial stress”.[vii] Under these guidelines you have two options for your calculation: either you utilise the standardised schedule approach approved by the applicable regulator (GRID) or an internal model (ISDA’s Standard Initial Margin Model (SIMM) is the only model that is currently approved by EU and US regulators).
BCBS-IOSCO stress that market participants cannot switch between these two approaches “in an effort to ‘cherry pick’ the most favourable initial margin terms.”[viii] Firms need to choose the same method “for all transactions within the same well-defined asset class.” [ix]
Whilst on the face of it the GRID method seems simpler than SIMM, it has proven to be complex and results in higher IM values. It has not been widely implemented during previous phases and ISDA criticised the approach for not being risk-sensitive, labelling it as a “(costly) fallback option” which appears to only serve to “motivate market participants to use the alternative internal model approach”.[x]
The GRID methodology does not require input from third party providers; here, a firm simply determines the applicable notional, maturity and market values for the transactions within their regulatory margin portfolios.[xi] This method uses margins based upon tables, approved by the respective regulator, which apply different percentages to in-scope derivative notional amounts by product type and tenor. This can become complex when each regulator applies different product rules. [xii] Further, this method provides operational challenges in the identification of netting sets to which the table must be applied. ISDA have advised that this method “typically leads to an overestimation of margin requirements and, more importantly, … the level of IM does not vary proportionally with any reasonable risk measure of the position”.[xiii]
By contrast ISDA developed their own internal model for calculating IM, known as SIMM. This approach considers the offsetting risks in a derivatives portfolio and generates a significantly lower IM amount than GRID; ISDA estimated that the GRID method will generate IM 2.8 times greater than the amount calculated using SIMM.[xiv] The SIMM approach is intended to create efficiency through netting of exposures, applying a sensitivity-based calculation across Interest Rate, Credit (Qualifying & non-Qualifying), Equity, Commodity and FX products.[xv]
To better understand the benefits and governance associated with each method I recommend reading the ‘Initial Margin for Non-Centrally Cleared Derivatives: Issues for 2019 and 2020’ White Paper.[xvi] Be mindful, however, that regardless of which method you choose, when it comes to margin disputes it is for obvious reasons easier and quicker to resolve when both parties to the trade are using the same methodology.
Time is of the essence – FinTrU can support you through the process:
While most market participants are now familiar with the VM rules, the rules for IM will be unfamiliar ground for many, particularly for those on the buy-side.[xvii] Those who do not align their collateral documents with jurisdictional requirements, or who fail to be operationally prepared prior to September this year, will be unable to trade non-centrally cleared derivatives.
The scale of what is required ahead of the deadline for each phase is colossal. The dealer group spent years reviewing their data, building internal systems and engaging third parties to support remediation efforts ahead of the deadlines. It was a wrought process and adherence to custodial, as well as regulatory, deadlines are of vital importance to prevent interference with trading. Special caution must be given to the limited time period between now and Phase 5 go-live; the dealer group was a much smaller population and Phase 5/6 readiness will hinge on a party’s ability to engage third parties early on. There will inevitably be overcrowding and a backlog that will ensue in the months before the go-live of each phase. ISDA warns that non-compliant parties will find they are “unable to access their historical OTC trading venues and may require alternative means to hedge their exposures.”[xviii] Take heed of this – the product diversity and customization for which the OTC market is recognised are not, for obvious reasons, core attributes associated with cleared derivative alternatives.
So how do you ensure that you are not blocked from trading those products that currently best meet your requirements? At FinTrU we have a proven track record assisting our clients with regulatory compliance. Let us help you navigate your requirements for IM Phase 5 and Phase 6 - we can offer cost effective solutions to assist with project management, drafting, negotiation, client outreach and more. For more information please contact: firstname.lastname@example.org
[i] Basel Committee on Banking Supervision Board of the International Organization of Securities Commissions publication, “Margin requirements for non-centrally cleared derivatives”, September 2013. https://www.iosco.org/library/pubdocs/pdf/IOSCOPD423.pdf
[ii] Basel Committee on Banking Supervision Board of the International Organization of Securities Commissions publication, “Margin requirements for non-centrally cleared derivatives”, July 2019. https://www.bis.org/bcbs/publ/d475.pdf
[iii] ISDA published an exclusive list in 2019 which can be found here: https://www.isda.org/a/HHhME/ISDA-In-Scope-Products-Chart_UnclearedMargin_08Aug2019.pdf
[iv] ISDA in a letter to BCBS and IOSCO, ‘Margin Requirements for Non-Centrally Cleared Derivatives’, 25 March 2019. https://www.isda.org/a/BunME/ISDA-Letter-Phase-V.pdf
[v] Basel Committee on Banking Supervision Board of the International Organization of Securities Commissions publication, “Margin requirements for non-centrally cleared derivatives”, March 2015. https://www.bis.org/bcbs/publ/d317.pdf
[vi] Basel Committee on Banking Supervision Board of the International Organization of Securities Commissions publication, “Margin requirements for non-centrally cleared derivatives”, July 2019. https://www.bis.org/bcbs/publ/d475.pdf
[x] ISDA article, ‘Margin Requirements for Non-Cleared Derivatives’, Rama Cont, April, 2018. https://www.isda.org/a/KV9EE/Margin-Requirements-for-Noncleared-Derivatives-April-2018-update.pdf
[xi] ISDA website, ’Are you faced with Initial Margin Calculation Challenges’. https://www.isda.org/a/3FWTE/Implementing-Initial-Margin-Model-vs.-Grid-17th-Oct.pdf
[xii] ISDA article, ‘Margin Requirements for Non-Cleared Derivatives’, Rama Cont, April, 2018. https://www.isda.org/a/KV9EE/Margin-Requirements-for-Noncleared-Derivatives-April-2018-update.pdf
[xiv] ISDA and others in a letter to ESMA, ‘Margin Requirements for Non-Centrally Cleared Derivatives – Initial Margin Models’, 17 May 2019. https://www.isda.org/a/Y3tME/2019.05.17_EU-Letter_IM-Models_FINAL.pdf
[xv] ISDA Article, ‘ISDA SIMMTM Methodology, version 2.2’, 3 September 2019. https://www.isda.org/2019/09/03/isda-publishes-isda-simm-v2-2/
[xvi] ISDA and the Securities Industry and Financial Markets Association (SIFMA) white paper, ‘Initial Margin for Non-Centrally Cleared Derivatives: Issues for 2019 and 2020’, 19 July 2018. https://www.isda.org/2018/07/19/initial-margin-for-non-centrally-cleared-derivatives-issues-for-2019-and-2020/
Vice President - Legal
Jacqui is an England & Wales qualified solicitor with over 5 years’ experience in Financial Services. She holds a law degree from Queens University, Belfast and completed her the Legal Practice Course at De Montford University Leicester.
Prior to joining FinTrU, Jacqui spent two years at Citigroup Global Markets Limited as an ISDA and Structured Products legal negotiator. During this time, she gained extensive experience over a wide range of legal documentation and supported multiple regulatory projects. In addition to her Financial Service experience, Jacqui has a strong background in continuous improvement and change management spending over 3 years in process improvement roles.
Within FinTrU Jacqui is a member of the senior management team with previous responsibility for Equity documentation negotiators supporting a Tier 1 Investment Bank. More recently she has moved into a new role leading a team supporting the Fixed Income division of a Tier 1 investment Bank, in both BAU documentation and regulatory project functions.
Founded in December 2013, FinTrU is a multi-award winning Financial Services company that is committed to giving local talent the opportunity to work on a global stage with the largest international investment banks. FinTrU provides its clients with high quality, cost-effective, near-shore resourcing solutions. FinTrU’s products are: Legal, Risk, Compliance, KYC, Operations and Consultancy. Its clients are all Tier 1 Investment Banks based in London, New York, Tokyo, Frankfurt and Paris. FinTrU currently employs 360 staff at its two Belfast city centre offices and Derry/Londonderry.