Lessons from UMR phase five

Sponsored Q&A

Lessons from UMR phase five

A forum of industry leaders discusses how buy-side firms should prepare for uncleared margin rules (UMR), implementation priorities for phase six firms and how vendors are adapting their services to ease the process of managing derivatives portfolios and collateral

The panel

  • Hiroshi Tanase, Executive Director, Product Analysis and Design, S&P Global Market Intelligence
  • Neil Murphy, Business Manager, TriOptima, OSTTRA
  • Amy Caruso, Head of Collateral Initiatives, Isda
  • Brendan Byrne, Head of Collateral Management and OTC Reform, Suncorp Bank

What has phase five taught us about how buy-side firms should prepare for UMR, and what impact is the increasing volume of firms having on the industry?

Hiroshi Tanase, S&P Global Market Intelligence
Hiroshi Tanase, S&P Global Market Intelligence

Hiroshi Tanase, S&P Global Market Intelligence: The biggest lesson learned is that firms must start their preparation early. In addition to setup, a lot of time needs to be spent on validating and understanding initial margin (IM) calculations. Even if a firm outsources IM calculation, regulators hold the firms responsible for sufficiently understanding the calculation process. For this reason, many phase five firms ended up spending more time preparing than they had expected to.

Amy Caruso, International Swaps and Derivatives Association (Isda): The key lesson is that compliance takes much longer than people think. Preparing for phase five was challenging for all parties involved because of the amount of custodian and counterparty documentation that was necessary. Many phase five entities prioritised completing their preparations with specific counterparties as a result, with those relationships under the €50 million IM threshold being completed later. This meant there was no significant market disruption on September 1, 2021, but the challenges will be significantly greater this time around because of the much larger number of counterparty relationships that will fall into scope – roughly double the number caught by phase five.

Firms can take steps to reduce the risk of bottlenecks and delays. For example, significant efficiencies can be achieved by negotiating regulatory-compliant credit support documentation and certain custodians’ account control agreements via the Isda Create online platform. This will help streamline onboarding, as the outputs can be fed digitally to the operating systems of the firms and their custodians.

In-scope entities also need to be prepared for the operational impact of the IM calculation process and increased margin call, settlement, substitution and recall volumes. Straight-through processing (STP) and automation will be critical for firms to reduce the operational, liquidity management and counterparty risk factors that come with posting and receiving IM.

Phase six firms should not underestimate the time and resources needed to prepare for calculating IM, whether via a third-party vendor or an in-house system. Testing and co-ordination with all counterparties will be critical for September 1 success.

Neil Murphy, OSTTRA
Neil Murphy, OSTTRA

Neil Murphy, OSTTRA: Similar to phase five, a large proportion of phase six firms foresee their IM exposures remaining below the €50 million regulatory threshold for some time, allowing them to take advantage of regulatory relief. However, phase six firms should proceed with caution. For some phase five firms, IM exposure increased much faster than anticipated, necessitating the exchange of collateral, which for some also required a scramble to complete legal documentation and custodian onboarding. Reasons for this include market volatility, unexpected growth in new business and, for some, a poor upfront understanding of standard initial margin model (Simm) calculation. To ensure market access in the weeks and months after the deadline, firms should establish baseline documentation with a subset of counterparties and begin steps for custodian onboarding.

As more firms fall into scope, the industry faces increased complexity with juggling the documentation challenge. That so many phase five firms deferred IM credit support annex (CSA) documentation prior to September 1, 2021, creates a legal hangover, with phase six firms now competing not only with each other, but also with phase five firms seeking to paper with their counterparties. Even phase six firms that are happy to defer formal IM documentation may find themselves caught up in delays to agree informal monitoring terms, as dealers face enquiries from hundreds of counterparties simultaneously.

Brendan Byrne, Suncorp Bank: Buy-side firms should start preparing early for UMR. They should start now if they have not already, as phase six is a very crowded space.

They should engage with their collateral management vendors as well as their sell-side counterparties as soon as possible, as they are likely to be inundated with enquiries. Firms may wish to consider setting ‘soft’ IM thresholds with counterparties to act as an early warning to prepare documentation and operations to post IM.

Firms should be aware of their local regulatory requirements as these differ across jurisdictions. Even if they are using Isda’s Simm for IM calculation, the model may still need to be independently validated, backtested and approved by their regulator. This will take time, particularly given the number of firms seeking to be UMR-compliant by September.

What should the implementation priorities be for phase six firms ahead of the September 2022 deadline?

Amy Caruso, Isda
Amy Caruso, Isda

Amy Caruso: If they haven’t done so, firms should immediately calculate whether they exceed €8 billion in average aggregate notional amount (AANA) of non-cleared derivatives, and notify their asset managers and counterparties if they think they will be in-scope. Any entity that uses separately managed accounts overseen by multiple asset managers must calculate its swaps exposure across all accounts and notify each asset manager if it expects to breach the compliance threshold.

The know-your-customer and onboarding process with new custodians as both pledgor and receiver must be completed months in advance of the September 2022 deadline. Firms also need to have their IM calculation and threshold monitoring capabilities well in hand and fully tested ahead of September 1.

Neil Murphy: Early estimation of IM should be a priority for phase six firms. Once this is known, firms can assess the broader impact on each portfolio, determining which relationships require legal documentation or whether they can take advantage of regulatory relief.

To be ready in time to guide the project, firms will probably need to have completed this step early in the second quarter of 2022. At that point they should also be making good progress in terms of onboarding, if leveraging an external IM provider.

Other implementation priorities – such as custodian onboarding or collateral preparations – are determined by the early estimation of IM exposure. Given lengthy custodian onboarding timelines, firms expecting to require a custodian from day one should prioritise this. Firms expecting to monitor only may be well advised to review custodian documentation, select a preferred provider and undertake preliminary onboarding steps.

Brendan Byrne: Phase six firms should understand where they are ahead of the September 2022 deadline. They may not need to organise third-party custodians or negotiate IM CSAs at this stage if they expect to be below the IM threshold.

If firms expect to post IM, consideration should also be given to how this could work operationally and be recorded in their collateral systems, as IM will settle to external accounts and be treated differently to variation margin (VM).

Hiroshi Tanase: It is crucial to review their requirements and put a strategic plan in place for achieving UMR compliance. In relation to IM calculation and exchanging margin, the critical decisions to make are:

1. Whether to use the Simm or Grid-based calculations (schedule IM) as a margin model

2. Whether to go live with IM threshold monitoring only, or with a fully operational set-up to exchange margin.

Once these decisions are made, a firm can focus on its preparation with a chosen service provider.

What factors do phase six firms need to consider in their choice of margin model?

Hiroshi Tanase: Unlike firms in the earlier phases, Simm is not always the suitable margin model for phase five and six firms. That is because some firms have highly directional and non-diversified portfolios, which can make Grid a more economical choice than Simm. Since Simm is a risk-based model, a portfolio that does not have a sufficient degree of risk offsetting may not benefit from using it. However, the decision between using Simm or Grid must be made carefully with thorough testing and a careful assessment of the factors that contributed to the result. Is the test result, favouring either Simm or Grid, specific to the portfolio tested? Can similar results be expected with future portfolios? The optimal choice of the margin model depends on the answers to these questions. Therefore, a firm must not only review test results, but assess how it intends to trade over-the-counter (OTC) derivatives in the future.

Amy Caruso: From a risk-based perspective, firms need to look at their trading strategies to ensure they would benefit from netting under the Simm. For example, if firms have a directional portfolio, then they would not realise that benefit. If they do choose to use the Simm, then they need to understand their operational and technological capabilities and determine if using a licensed Isda Simm vendor would be more efficient than implementing the model internally.

Brendan Byrne: Phase six firms should consider what model their counterparties are using (probably Simm). If firms expect to post IM, they will need to agree the IM amount with their counterparties each day. An IM calculation reconciliation process may need to be set up to understand and manage any differences. They should also review the resources they have to validate, backtest and maintain the model.

Neil Murphy: When selecting a margin model, a key factor is the model’s ‘fit’ for a specific portfolio (in some cases Simm may be lower or higher), but a more crucial factor is a firm’s ability to support that model – either via existing risk platforms or the use of a dedicated IM calculation engine. If using Simm, firms must also consider the added complexity of the calculation, as well as additional market data requirements.

Firms may also find themselves required to meet regulatory governance requirements, where they must provide additional documentation to support their choice of model, ongoing risk governance and backtesting of IM results.

The key question for phase six firms is: ‘Which model allows me to take advantage of regulatory relief for the longest period?’, with a broad assumption that, in most cases, the Simm methodology will result in lower IM exposure, providing a longer grace period. For portfolios where Simm does not provide significantly lower numbers, firms can choose the simpler approach of Grid methodology.

How is UMR changing the way firms manage their derivatives portfolios and collateral?

Amy Caruso: Firms are looking closely at their trading strategies to determine if cleared products can be used as effectively as non-cleared derivatives to remain under the AANA and/or the €50 million IM threshold. In addition, firms may look to diversify their trading with additional counterparties to remain under the IM threshold per counterparty group.

Phase six entities may have primarily used cash for VM in the past, but there are challenges with posting cash as IM. Firms are therefore looking to expand their collateral inventory to include Treasuries and corporate bonds. We anticipate firms will look at additional sources for margin in the future, but some phase six entities are trying to keep their collateral pool straightforward and limited at this time.

Brendan Byrne: Firms will look to trade compression to reduce notional for IM calculation. They will also potentially trade away from counterparties that are approaching the IM threshold. Finally, UMR is prompting them to sign Isda cleared derivatives execution agreements with counterparties and to clear more transactions centrally.

Hiroshi Tanase: UMR is changing how firms trade OTC derivatives. For many firms, it means additional operational workload and cost. But, for more progressive firms, it means there is a need to proactively assess the cost of margin for trading uncleared derivatives. Margin optimisation – for example, choosing the best counterparty to trade the next trade considering IM cost – will become an important part of trading in the future.

Neil Murphy: UMR can lead to changes in firms’ behaviour, pre- and post-trade. From a pre-trade perspective, some firms are seeking to avoid UMR completely by reducing their AANA ahead of May 31, reducing the size of their portfolios via compression or, where possible, moving to clear more trades. However, once in-scope, some firms seek to optimise IM by assessing which counterparty a trade should be booked with, either taking advantage of regulatory thresholds with a broad range of counterparties or selecting a portfolio where the IM impact will be minimised.

While the forced switch to non-cash collateral might appear the biggest change for many collateral managers as part of UMR, the most significant impact is one of technology, as firms play catch-up to improve their operational capacity, streamline processes and adopt industry standards.

How are vendors adapting their services to ease the process for phase five and six firms? Which innovations have made the greatest impact?

Brendan Byrne, Suncorp Bank
Brendan Byrne, Suncorp Bank

Brendan Byrne: TriOptima is providing a single solution for VM, IM and trade reconciliation. And STP and automation of margin calls via connectivity to Acadia will help with increased margin call volumes.

Neil Murphy: For many phase five/six firms, UMR presents an opportunity to re‑evaluate their broader collateral technology stack. UMR-specific requirements such as IM margin workflows and support for non-cash collateral sit alongside broader requirements for end-to-end automation, connectivity to industry reconciliation platforms, electronic messaging and Swift settlement. Helping firms prepare requires a fast and simple adoption path, which is likely to necessitate the use of cloud technology. Firms now recognise that this path allows them to quickly follow regulatory change with immediate access to new features.

Key changes noted among phase five/six firms include new requirements to dynamically monitor IM exposure – alerting users when predefined tolerances are breached – and new requirements to provide clients with automated connectivity to a range of custodians and tri-party agents via Swift. TriOptima has observed that settlement automation has provided perhaps the biggest win for clients, with our turnkey Swift access eliminating the need for complex integration with multiple custodians, syncing margin and settlement workflows, removing dependency on fax, automating collateral payments and providing real-time settlement insight.

Hiroshi Tanase: The fact that efficient and effective solutions are available from vendors is a boon to the industry, which was not the case in the first phase of UMR in 2016. The outsourced solutions are more scalable now, albeit with differences in quality across providers. Some vendors, including S&P Global Market Intelligence, provide a holistic solution covering the entire workflow – from capturing trades, valuation, IM calculation and moving collateral, and margin optimisation. The greatest innovation is that leading providers recognised the unique needs of firms and created a holistic solution that connects multiple key elements seamlessly.

Amy Caruso: Vendors have numerous services that can help phase five and six entities with compliance. Multiple vendors have licensed the Simm to allow firms to adopt it without having to implement their own model. AANA calculation and IM threshold monitoring services are also available, which can help firms determine if their legal entities or their clients’ legal entities and counterparty relationships are in-scope.

Advisory firms and legal support services can be used to manage counterparty and custodian documentation workflows. In addition, collateral administrators and utility services have expanded their offerings to accommodate automated margin call, settlement, reporting and optimisation.

Given the challenges with legal documentation negotiations and managing eligible collateral, the industry is also developing new standards and solutions, including using Isda’s common domain model – which establishes a common set of representations for trade events and processes – to develop digital documentation and eligible collateral representation.

The panellists’ responses to our questionnaire are made in a personal capacity, and the views expressed herein do not necessarily reflect or represent the views of their employing institutions


Initial margin – Special report 2022
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