In September 2022, the sixth and final phase of the Uncleared Margin Rules (UMR) in the U.S. and EU will take effect. The regulation may force significant changes in the way collateral is posted or collected as initial margin (IM) for over the counter (OTC) derivatives.1 Its scope is immense: the International Swaps and Derivatives Association (ISDA) estimates that more than 775 counterparties with an excess of 5,400 relationships may become subject to IM requirements in Phase 6.2
Understanding the impact of this final phase requires a look at the journey to regulate derivative instruments so far.
The Road to Increased Regulation
The 2008 global financial crisis demonstrated that many of the derivatives transactions that were executed bilaterally were uncollateralized or under-collateralized. Policy-makers concluded that these bilateral transactions increased the financial system’s interconnectedness and that the lack of centralized information on OTC derivatives transactions contributed to uncertainty among market participants and policy-makers over counterparty exposures.
Several new regulations were introduced, creating a significant impact in changing the collateral landscape. These include:
- The European Market Infrastructure Regulation (EMIR) - lays down rules on OTC derivatives, central counterparties and trade repositories.
- The Dodd-Frank Wall Street Reform and Consumer Protection Act (the Dodd-Frank Act) - title VII Act contains the U.S. framework regulating OTC derivatives (swaps), including its G20 commitments for the reporting, clearing and exchange trading, as well as margin requirements for non-cleared swaps.
- Basel III - addresses the capital and liquidity requirement of banks and pushes them towards centralized clearing of their OTC derivative transactions.
The shift to central clearing and margin requirements for non-cleared derivatives transactions therefore was intended fundamentally to decrease counterparty credit risk. Margin requirements for derivatives transactions that would remain uncleared were supposed to reduce counterparty risk by ensuring that collateral is available to offset losses caused by a counterparty default in bilateral transactions.3
Initial margin rules for non-cleared derivatives were first introduced in 2016 by U.S. prudential regulators and European regulators as part of financial reform initiatives: the rules were rolled out with a phased implementation timeline. The Basel Committee on Banking Supervision (BCBS) and the International Organization of Securities Commissions (IOSCO) agreed to the following:
- Minimum standards for margin requirements
- Standardization of initial margin calculation methodology:
- Grid (a table-based methodology)
- Standard Initial Margin Model (SIMM)
- Initial margin exchange guidelines.
The first five phases of implementation of initial margin rules have had a limited direct impact to BBH’s clients due to their aggregate average notional amount (AANA) of non-cleared derivatives4 not meeting the established thresholds. With the final phase of implementation, and with the thresholds reducing to USD$8billion, the firm expects to see more of its client base impacted by the initial margin requirements (see implementation plan below).
As mentioned above, the last phase will take effect in September 2022: on the buy-side the pension fund and traditional asset manager community will be impacted significantly. By that date, many non-cleared swap counterparties will be required to post and collect initial margin to meet the regulatory requirements.
|Uncleared Margin Rules Phased Implementation Plan|
|Implementation Date||Entities Impacted|
|September 1, 2016||Counterparties with an Aggregate Average Notional Amount (AANA) of non-cleared derivatives threshold $3 trillion|
|September 1, 2017||Counterparties with an Aggregate Average Notional Amount (AANA) of non-cleared derivatives threshold $2.25 trillion|
|September 1, 2018||Counterparties with an Aggregate Average Notional Amount (AANA) of non-cleared derivatives threshold $1.5 trillion|
|September 1, 2019||Counterparties with an Aggregate Average Notional Amount (AANA) of non-cleared derivatives threshold $750 billion|
|September 1, 2021||Counterparties with an Aggregate Average Notional Amount (AANA) of non-cleared derivatives threshold $50 billion|
|September 1, 2022||Counterparties with an Aggregate Average Notional Amount (AANA) of non-cleared derivatives threshold $8 billion|
While the Uncleared Margin Rules focus on derivatives, it also impacts securities lending participants, especially those on the buy side. In this case, buyside firms will have to utilize securities lending programs to substitute and enhance their collateral. They will need to access collateral that is eligible for initial margin and ensure their counterparties are in agreement regarding the type of collateral that will be made available.
Spot and physically settled forward foreign exchange forwards do not fall within the scope of UMR , but this does not mean the rules have no effect on traditional FX business. FX forward exposures count towards a client’s Average Aggregate Notional Amount (AANA) threshold calculation together with other kinds of FX exposures. In view of the impact to OTC FX activity, many firms are considering switching to cleared arrangements.
The UMR will have impact on post-trade services providers: the regulations will require the posting and segregation of initial margin for non-cleared derivative transactions at an independent third-party custodian or tri-party agent. Historically, the pledge-and-release process has had many operational inefficiencies, but the industry has been making strides in bringing solutions to the market to provide automation and scale opportunities. There will be increased pressures to open and maintain collateral accounts at custodians or third-party entities in a timely manner while also working to streamline the negotiation of Account Control Agreements (ACAs) between clients/asset managers, custodians and broker/dealers. In addition to the need to open and manage new collateral accounts, there will be increased cash and securities movements, compressed settlement timelines and a greater demand on same day settlements.
What is BBH Doing to Prepare and Assist Clients?
BBH is making improvements to the collateral account set-up process to create efficiencies, build scale, and minimize delays associated with collateral account setup. The firm is also working with broker/dealers where applicable to prepare standard templates to be used for the agreement negotiation. BBH has been a leader in the onboarding of clients to the Global Custodian (GC) Direct utility, which is used to streamline the management and maintenance of standard settlement instructions (SSI) details for both standard accounts and collateral accounts. The automated interface with GC Direct greatly decreases fail rates and improves settlement timeliness. BBH has also invested in the development of an internal collateral tracking facility to help manage the capture and reporting of collateral transaction details.
The firm anticipates needing to support multiple collateral operating models based on decisions made by our clients. We currently see the need to support three different instructional models:
- Connectivity with DTCC-Euroclear Global Collateral Limited’s Margin Transit Utility (MTU)
- SWIFT MT527 messaging5
- Tri-party collateral agents.
BBH has built connectivity with the MTU supporting clients who decide to contract with DTCC-Euroclear Global Collateral Ltd. The MTU automates a historically manual pledge-and-release process, thereby providing users with an STP solution for the processing and settlement of collateral and streamlined operational efficiencies. Once the margin call has been agreed, the MTU interfaces with ALERT to enrich with SSI details and provides the custodian with standard SWIFT MT54x and MT202/210 messaging. BBH will require authorization from clients to accept instructions from the MTU, and in the event an account control agreement is relevant, then an instruction from the client’s counterparty will also be required.
BBH will also support clients and their counterparties who choose to use SWIFT MT527 messages for the pledge-and-release process. The MT527 message provides an alternative to fax, which tends to be the current process still used by many to instruct a release of collateral. The MT527 would be used by the secured party to instruct the release of collateral back to the pledgor. This provides market participants another way to manage the pledge-and-release process.
BBH has seen an increase in client and broker inquiries regarding the ability to support MT527 messaging and anticipates seeing more clients adopt this message standard in place of utilizing the MTU and a tri-party agent. The MT527 message is not widely used in the industry today and there is still work to do from an industry standardization perspective to fully support and automate the release authorization associated with the MT527 message to match the MT527 to the corresponding client instructions.
Lastly, asset managers may elect to use a tri-party agent. If a client chooses to use a tri-party agent to manage their collateral/initial margin processes, BBH will work directly with its clients to build connectivity with the specified tri-party agent to ensure the books and records at BBH accurately reflect what is in BBH’s custody versus that which is held at a tri-party agent. Tri-party agents act as an independent collateral agent to manage the collateral lifecycle.
What Should Clients Do to Prepare?
Clients should be taking the following steps to ensure preparedness:
- Analyze your derivatives portfolio to identify the trades that will be subjected to the new margin rules
- Calculate your Aggregate Average Notional Amount to determine implementation date and self-disclosure
- Ensure the model used is scalable as counterparties will be subject to periodic stress testing
- Determine tools and technology you will employ for IM Calculations: SIMM or regulatory tables (grids)
- Ensure collateral management operational teams are equipped to manage your IM needs and the proper operational infrastructure is in place or being developed to optimize collateral
- Determine the best collateral operational model to support your business (i.e. Third-Party Collateral Accounts, Tri-Party Collateral Agents, MT527 messaging)
- Work with your counterparties to determine which custodian will be used to post and hold initial margin
- Determine if you will use cash as collateral and work with your custodian to understand capabilities to invest cash into overnight vehicles to minimize/diversify credit risk
- Work with your custodian to identify the number of new collateral accounts that will need to be opened and ensure your designated custodians can support
- Negotiate new agreements as needed.
Additional Reference Tools
1 A financial contract that does not trade on an asset exchange, and which can be tailored to each party's needs.
2 Countdown to Phase 6 Initial Margin – International Swaps and Derivatives Association (isda.org).
4 Average Aggregate Notional Amount (AANA) is a calculation to determine the scale of a firm's activities and positions in non-centrally cleared derivatives trading.
5 This message is sent by a trading party to its tri-party agent to instruct the agent to perform a specific action on a collateral management transaction.
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