IM phase five – Smaller on bang, bigger on complexity

The initial margin (IM) ‘big bang’ may have been reined in by last-minute relief, but dealers aiming to get hundreds of buy-side firms over the documentation finish line by September 1, 2020 fear a compliance bottleneck.

Regulatory recommendations issued in July split the final phase of compliance with non-cleared margin rules in two. Firms with more than €50 billion in aggregate average notional amounts (AANA) of bilateral derivatives remain in phase five, while those with AANA down to €8 billion are part of a new sixth phase, scheduled for September 2021.

An additional reprieve allows in-scope counterparties to continue trading without documentation in place, providing margin exchange amounts do not exceed €50 million per counterparty relationship. European Union regulators also granted equity options an additional one-year carve-out from the rules, aligning with the US, where the products are exempt. 

The relief helps avoid a cliff-edge, but also introduces an extra layer of monitoring complexity. What’s more, the numbers remain alarming and the timeline is short. Although analysis suggests the phase-five cohort has been slashed from 1,000 counterparties to just over 300, this still translates to more than 3,600 counterparty relationships, requiring negotiation of more than 21,000 new documents, including credit support annexes, custody account control agreements and eligible collateral schedules.

It’s more than five times the number of firms caught in the first four phases combined, and the largely buy-side assemblage presents new challenges.

In-scope firms need to decide whether to follow sell-side counterparties in using the industry-developed standard initial margin model (Simm) for calculating IM. Those with directional portfolios, which do not benefit from Simm netting, may opt for standard ‘grid’ schedules. It is also thought alternative buy-side-friendly margin models could emerge as more are caught in the net.

Some of the class of 2020 are unfamiliar with posting collateral against non-cleared trades, but many already post non-regulatory margin in the form of ‘independent amounts’ (IA). IA calculated by dealers may be higher than regulatory minimums required under Simm or grid. For example, Simm excludes jump-to-default risk for margining credit default swaps. This is usually included in dealers’ in-house models and would continue to be charged to clients post-compliance.

This can complicate preparations as it requires buy-side firms to set up segregated custody accounts in a way that allows for posting of both regulatory and non-regulatory margin. They must also navigate two similar-sounding but different routes – tri-party and third party. 

There’s already a precedent to combine both account types. Buy-side firms caught in phase-four set up tri-party segregated custody accounts for regulatory IM, while retaining existing third-party custodians for the net difference between regulatory and IA measures. While it’s a good starting point for phase-five firms, dealers warn the choices made by a handful of hedge fund giants may not be the best long-term option for buy-siders of all stripes. 

The €50 million exchange threshold also presents unique challenges. Analysis by the International Swaps and Derivatives Association shows the number of counterparty relationships to be repapered is further reduced by more than two-thirds thanks to this reprieve. It’s a welcome move, but requires continuous exposure monitoring. In Europe, using Simm for monitoring purposes could expose firms to the full IM documentation burden as EU rules require firms to gain model approval.  

Monitoring is a particular challenge for multimanaged accounts, which split investment across a range of funds. This requires close co-operation across individual funds to determine how the threshold is distributed across the parties.

Deadlines have a knack of creeping up quickly. Custodians slapped a June date for account applications on earlier phases. For phase five, there’s talk of an earlier deadline to wade through the rush of cumbersome know-your-customer checks. That’s yet to be decided but, if there’s any chance of avoiding a bottleneck, a preparation big bang will be required in the new year.

Initial margin – Special report 2019
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