Firms face many challenges as deadlines loom for phases five and six of the uncleared margin rules (UMR), including getting their average aggregate notional amount (AANA) calculations right to determine which phase they are in. With only three months to prepare, further complications related to an overload of firms aiming to complete the same steps may leave phase five firms with many options closed to them. Neil Murphy, business manager at TriOptima, highlights the critical steps for phase five and six firms, offering insights into priorities, potential pitfalls and solutions to meeting these deadlines
Only about 70–75 firms have come in-scope of UMR since 2016 across phases one to four. However, we are expecting more than 300 phase five firms in September 2021, and upwards of 600 phase six firms in September 2022. What are the challenges for the industry related to the sheer volume of firms coming in-scope of UMR?
Neil Murphy: Firms will be relying on common resources: vendors, lawyers, consultants and even regulators. They will be trying to complete the same steps – be they onboarding to a tri-party or custodian – or negotiation of legal documentation with the same four tri-parties and maybe the same 10–15 dealer banks. A critical consequence of this, potentially, is increasingly limited choices. For example, we have seen tri-parties and custodians establish onboarding cut-off dates earlier in the year. So, firms looking to onboard between now and September 1 may find some of their paths closed. Similarly, firms that want to sign regulatory initial margin (IM) credit support annexes (CSAs) with all of their dealer counterparties may find dealers being more selective at this point, perhaps looking to onboard premium clients first, or less open to negotiation of the underlying CSA terms.
What of AANA calculation and how phase five and six firms should approach this?
Neil Murphy: The AANA calculation is critical. It is a key identifier of when a firm is in-scope. Given the importance of determining the phase, it is important to get it right but also to do it early. The most recent AANA observation window effectively ended in May, which would only leave three months for a firm to prepare for September, which is unlikely to be sufficient.
For firms not yet in-scope, there are several nuances to the AANA calculation relating to data. Chief among those is the aggregation of multiple data sources. When firms are thinking about AANA calculation, the first step is to perform the calculations at the group level and identify all the relevant entities in the group. The consolidation of data for all positions across the group can present a challenge when derived from multiple sources. This creates an additional hurdle for multi-manager firms where each manager has only a limited view of exposure. Firms may also face challenges in relation to differences across various jurisdictions, impacting product coverage, calculation methodology and observation windows.
Questions remain about accounting for the correct notional on certain product types, and there are calls for further guidance from rulemakers.
How much progress have phase five and six firms made, and how should they prioritise their efforts?
Neil Murphy: The industry has always talked about UMR compliance as requiring a one-year-plus project, but it’s not a hard and fast timeline. Critically, the rules don’t impact all firms equally. So firms who expect their IM exposure to grow quickly will require different preparation steps than firms that may be brought in-scope by the size of their AANA but expect their IM exposure to remain very low, and can take advantage of regulatory relief.
Regardless of the size of the firm – or even the expected IM impact – all firms are focused on the IM calculation as their key priority. My key recommendation to clients is that they should perform this calculation as early as possible since, without it, I’m not sure they can confidently define a project plan, engage with counterparties or make decisions about their technology needs.
For firms that expect to quickly exceed IM thresholds and begin exchanging IM margin, we see that many have already moved to – or are about to move into – a soft go-live phase, whereby they’re performing daily IM calculations across their portfolios, engaging with counterparties to investigate differences and simulating what the process will look like after September 1.
I think getting to that stage ahead of the summer is a great position to be in. It will provide sufficient time to iron out calculation kinks and better understand how the standard initial margin model (Simm) impacts firms’ portfolios, and allow them time to work with their counterparties on reconciling differences. And, while a fair number of people are in this position already – and others hoping to be there by the end of the second quarter – there are still firms that will squeeze through the door at the last minute.
Do you expect a trend of firms using the AANA calculation and IM monitoring as part of UMR avoidance strategies?
Neil Murphy: UMR avoidance is more about reducing your AANA so you can delay the impact, or even perhaps remain out of scope, permanently. This is something that may be achieved by a change in trading strategy. For example, compressing a portfolio or clearing trades where you are eligible to lower overall positions. However, for any firm that manages to lower its AANA below $8 billion, the compliance obligation does not just disappear. Instead, these firms will be required to repeat that AANA calculation in subsequent years to verify whether they come in-scope at that point.
Once you breach the AANA threshold and you’re in-scope, you can’t avoid UMR. Granted, regulators have provided some relief, which means you don’t have to complete all of the legal documentation steps or open custodian accounts. But you are still required to perform IM calculation and monitoring. It means a lower compliance burden and less to undertake operationally if some of the steps can be delayed or do not apply.
What are the collateral processing needs associated with regulatory IM, and how do they differ from variation margin (VM) requirements?
Neil Murphy: At a high level, the IM calculation is quite similar to the VM call calculation. You compare your inputs – Simm or schedule exposure to the terms of the IM CSA – and any outstanding collateral balance. This determines whether additional collateral is required and whether a call should be issued. For VM, the mechanics are the same – simply replacing Simm with mark-to-market. But a key difference is that the exchange of IM is on a non-netted basis, which means two margin calls will be required, both receipt of IM and delivery of IM.
Other key differences relate to the exchange of collateral, which is likely to be non-cash. This will create new challenges associated with funding and settlement of securities for firms that have relied on cash for VM.
Perhaps the largest difference on the collateral side is the requirement for segregation of any collateral posted as IM. Phase one to four firms have largely adopted a tri-party model. This poses a steep learning curve for in-scope firms as they need to establish new tri-party relationships, onboard and upgrade their systems. And, in the tri-party model, the actual margin call process differs from VM, since no collateral is agreed for exchange, simply confirmation of the agreed exposure.
The greatest challenge around collateral for these firms is connectivity to tri-parties and custodians. Legacy processes tend to support cash and securities payments only, so firms will need to establish new ways of instructing payments, as well as ensuring firms have the necessary transparency to view any tri-party collateral allocations.
How would you contrast the firms now coming in-scope with phase one to four firms, and how do their needs differ from those in earlier phases?
Neil Murphy: The size of the IM exposure and the associated time to breach the regulatory threshold is the key difference for phase five and six firms. Many phase one to four firms exceeded IM thresholds very quickly, some even on day one. In contrast, IM may remain low for phase five and six firms for a long time, or even forever for smaller parties. So, IM monitoring will be sufficient for many; something that wasn’t even an option to firms in earlier phases.
Phase five and six firms require more comprehensive systems support than firms in earlier phases. They may require help with IM calculation and the margining process, as well as settlement. Firms in earlier phases were often able to reuse large parts of their existing infrastructure. They had more advanced risk systems capable of generating the underlying sensitivities, for example, and take-up among TriOptima clients was probably skewed towards collateral management, with many capable of managing their own IM calculations. In contrast, a large number of phase five and six firms require support for both IM calculation and collateral management, evidenced at TriOptima by strong adoption of both triCalculate and triResolve Margin.
In earlier phases, IM reconciliation was a day-one priority with close to 100% adoption of Acadia’s Initial Margin Exposure Manager (IMEM). In contrast, IM exposure will likely take more time to build up here. So there is less focus on IM reconciliation, and it will be interesting to see how firms will fare when they start to exchange IM calls or perhaps observe their first differences with counterparties since the question of how they are going to manage and resolve IM disputes may have been overlooked. In the VM world, there is a long-established process for portfolio reconciliation using triResolve as a centralised market standard, which can be mirrored for IM through the adoption of a similar standard for IM sensitivity reconciliation by means of IMEM.
To what extent has TriOptima adapted its service offering and operational setup in preparation for the latter UMR phases?
Neil Murphy: The first new function we have added is IM monitoring. The addition of a dedicated monitoring dashboard allows clients to measure their own IM (as well as counterparty IM) on a daily basis, compare it to a local or even an agreed soft threshold and receive an automated alert when that limit is breached. At that point, if they move to sign an IM CSA, they can seamlessly switch from monitoring to active margining.
The second key change we have introduced is connectivity to tri-parties with our new Swift settlement capability. We recognised early on that the obligation to connect – not just to your own preferred tri-party or custodian, but also to the tri-party of each of your counterparties – posed a significant technical hurdle for firms. A failure to connect to them would create a level of operational risk that is not acceptable to firms because the alternative would mean logging into custodian portals manually and even sending faxes. We now offer real-time settlement instruction across all tri-party agents.
Learn more about TriOptima initial margin compliance
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