Capital Markets Advisors

Turning Change Into Opportunity


Jul 29, 2014


New margin requirements for uncleared derivatives come in to force in 2015 and requires significant technological and operational investment. Big banks may well be prepared, but many institutions may be surprised to find themselves caught in the net. Grant Murgatroyd reports.

The clock is ticking. On December 1, 2015 large financial institutions will be subject to new, onerous, regulations for non-cleared margin requirements. Initially only institutions with over $3 trillion in outstanding gross notional (OGN) – 30 or so of the world’s largest banks – will be subject to two-way initial margin (IM) requirements, but over the next four years the rules will be phased in such that by 2019 institutions with more than $8billion OGN will have to comply.

The changes, brought in by the Basel Committee on Banking Supervision (BCBS) and the International Organization of Securities Commissions (IOSCO) as part of the response to the financial crisis, will have far-reaching consequences.

“This is costing the banks a lot of money in terms of getting the technology infrastructure in place and a lot of money in terms of capital cost,” says David Clark, chairman of the Wholesale Markets Brokers Association (WMBA). “But these costs are integrated with many of the other costs associated with calculating capital. You can’t look at them in isolation.”

Time will tell

BCBS/IOSCO have been consulting on the Margin Principles for two years since issuing its initial guidance in July 2012 and published its final policy framework in September 2013, but the final outcome remains unclear. The consultation has been heavily influenced by US regulators, with the Federal Reserve, OCC, FDIC, CFTC and SEC all represented on the working group. It is expected that national supervisory agencies will fully implement the global principles.

Experts say that the new revised policy framework reflects a more pragmatic approach, such as with the introduction of a €50m IM exposure per counterparty threshold before two-way margin is required. A 2012 Quantitative Impact Study estimated that the threshold would reduce total IM needs in the market by 56% (approximately €558bn) from the initial BCBS/IOSCO proposal. “The proposed expansion of collateral types eligible to satisfy these requirements could ease the strain on prime liquid securities and reduce the potential for a market-wide collateral squeeze,” says Christopher Scarpati, principal in PwC’s Financial Services Advisory Practice.

The proposed margin rules for uncleared swaps will have a profound impact on the global market. The requirement for satisfying margin deficiencies using highly liquid collateral and/or cash potentially further squeezes existing supply. This introduces additional costs and operational complexity for all covered counterparties, according to Scarpati. “The requirement of initial margin effectively shifts the uncleared derivatives market from a ‘survivor pays’ model to a ‘defaulter pays’ model by reducing the reliance on capital during periods of financial stress,” he says.

Casting the net

The rules have been designed to encompass systemically important financial and non-financial firms, but several significant organisations, including sovereigns, central banks, multilateral development banks and the Bank of International Settlements will be exempt. Crucially, the $8bn threshold means that all but the largest pension and hedge funds will be exempt.

Regardless of the final form of the regulations, participants need to move fast to prepare themselves for the new regime. “There’s probably at least 70% of the new regulations which you could say are pretty final and largely most people agree on what the rules should look like,” explains Nick Newport, managing director of consultancy InteDelta. “There’s probably about 10% where we are not at all clear and 20% which could go one way or the other. Most of the large banks are comfortable enough to go ahead and start implementing the vast majority of the elements as everything needs to be in place by December 1, 2015. The large banks can’t wait much longer to start implementing because it will take a long time.”

There are several elements that will specifically have a direct impact on the margin process itself. “I think they’ll impact all firms regardless of size or geography, something that’s going to be a surprise to a lot of them,” says Neil Murphy, director, Collateral Product Management, IBM Risk Analytics. “They could obviously require posting of additional collateral amounts and for some firms exchanging margin information on a more frequent basis.”

Too big to fail

It is the largest, systemically important financial institutions (SIFIs) that will be required to comply with the new regulations first, but for most of these it is simply a case of formally adopting best practice. The requirement under Dodd Frank for certain swaps to be cleared through a central counterparty (CCP) means that many of the requirements of the Basel/IOSCO principles are already being met. But that should not be taken as cause for complacency.

“The introduction of initial margin on a systematic basis is the major new item that’s going to need to be put in place,” says Newport. “Then there’s a whole raft of other things that are certainly well understood in the large banks and undertaken fairly systematically, such as use of eligibility schedules, concentration limits, haircuts and daily exchange of variation margins. But what the rules will enforce is that those need to comprehensively be put in place across all derivatives participants regardless of size or nature.”

The headlines – and the huge numbers for outstanding portfolio size in the phase in-schedule – are giving comfort to many market participants that their operations are outside of the scope of the regulations, but this may not be the case. “This only really applies for the initial margin aspects of trades,” says Murphy. “As recently as two or three months ago we were talking to clients and they were saying, ‘we don’t expect this to be hitting us until 2017’. The reality is that they will actually be hit much earlier than that, given changes to variation margin. There are definitely firms who have not realised that just yet.”

Clark agrees that global SIFIs are well prepared, but is less sure that is the case for smaller institutions; “Are the mid-tier banks fully prepared? It depends on how mid-tier they are. There are a lot of better rated banks that are probably SIFIs in their own country, and they would be fully prepared. There are some others – for example in Europe and Asia  – that are finding the technology piece challenging.”

Even if not directly affected by the regulations, clients of banks will face a range of costs. “There will be not just be legal and operational costs at managers, but also costs will be directly borne by clients associated with the provision of collateral and the potential impact on investment returns,” says Guy Sears, director, Risk, Legal and Compliance, at the Investment Management Association. “However, it is important to note that most clients of investment managers should fall outside of the requirement to post initial margin.”

Settle your differences – more disputes possible

Newport says that the new regulations bring increased potential for disputes, and that any disputes could potentially require more capital to be set aside.

“When a party makes a margin call and then expects the other party to agree it, people might be using different models to calculate it. That’s already difficult today, even with just the basic valuation models for derivatives,” he says. “But when it comes to risk-based margining methodologies then the scope for disagreements in the calculations is high, so that’s certainly going to be a difficulty.

The European regulations require that all parties use the same “haircut” models, which are a product of internal risk calculations. “Everybody’s got different internal risk calculations and the industry will not be aligning onto a single model for internal risk calculations because each individual firm needs to do what it thinks is appropriate,” says Newport. “The scope for disagreement around margin calls because of the calculations that are being used is quite high and that will give potentially large operational issues.”

Currency silos

“One of the bigger impacts of the proposed rules – and something that was perhaps not entirely expressed in the earlier draft – is that there’s been a move towards margining at the individual currency level rather than at a portfolio level,” says Murphy. “This alone would be the biggest driver for a significant increase in operational complexity and poses challenges to the implementation of the rules themselves.”

The individual currency provisioning is a deliberate stick that Basel/IOSCO are wielding to try and reduce currency risk. If two entities trade in euros and post collateral in dollars or yen, then there will be a penalty. The solution to that is to silo off the portfolio into currency pots, but as with other measures this brings with it additional complexity.

Margin is collected in many shapes and forms and many dealers have sophisticated and advanced systems to handle margin requirements. “There will be a strain on dealers’ operational and technology platforms as the proposed rule requires margin to be posted on a larger population of OTC transactions,” says Scarpati. “Dealers that do not really have sophisticated systems face a larger hurdle than dealers who have things like straight-through processing in place and will struggle to prepare for the increased activity.”

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