The Impact of Implementation

The global financial crisis identified a lack of transparency into the OTC derivatives market that exposed many market participants to risk. Regulators around the globe identified the need for greater transparency, oversight and regulation of the OTC market to limit excessive risk and exposure to market players. As such, several new regulations (EMIR, Dodd-Frank, Basel, etc.) have been introduced into the market creating a significant impact in changing the collateral landscape.


Implementation

Initial margin rules for non-cleared derivatives were first introducedin 2016 by US Prudential Regulators and European regulators as part of financial reform initiatives with the announcement of 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 three phases of implementation of initial margin ruleshave had a limited direct impact to BBH’s custody clients as a resultof their aggregate notional amount of non-cleared derivatives notmeeting the established thresholds. As we are coming up to the last two phases of implementation, BBH expects to see more of our client base impacted by the initial margin requirements. The last two phases will take place in September 2019 and September 2020 and will primarily impact the pension fund and traditional asset manager community. By September 2020, many non-cleared swap counterparties will be required to post and collect initial margin in order to meet the regulatory requirements. The scope of the impact of the final two phases will be widely felt across the industry and as a result many industry advocacy groups are pushing to have the scope of phase 5 re-evaluated and are pushing to see the Aggregate Average Notional Amount (ANNA) threshold increased.

Eyes on the Future: Data and the Next Lehman Crisis

The new 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. This will result in an increase in cash and securities movements and compressed settlement timelines. Historically, the pledge and release process has been fraught with operational inefficiencies; the industry has been making strides in bringing solutions to the market to provide automation and scale opportunities. Industry participants are looking to adopt the use of MT527 messages and some market participants are looking to leverage the Margin Transit Utility to achieve operational efficiency and reduce risk. There will be increased pressures to open and maintain collateral accounts by investors at custodians or 3rd 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 compressed settlement timelines and a greater demand on same day settlements.

What BBH is 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 the collateral account setup. BBH 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 GC (Global Custodian) Direct

streamlining the management and maintenance of SSI details for both standard accounts and collateral accounts. The automated interface with GC Direct has shown to greatly decrease fail rates, improving 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, capturing the collateral purpose codes and broker details.

BBH anticipates needing to be able 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)
  • MT527 messaging
  • Tri-party collateral agents

BBH was the first custodian to build connectivity with the MTU supporting clients who decide to contract with DTCC-Euroclear Global Collateral Ltd. The MTU provides streamlined operational efficiencies for the pledge and release process by automating a historically manual process. The MTU provides users with an STP solution for the processing and settlement of collateral. 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 our 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.

For clients and their counterparties who choose to use SWIFT MT527 messages for the pledge and release process, BBH will support this process. The MT527 message provides an alternative to a fax which tends to be the current process for instructing 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/release process. BBH has seen an increase in client and broker inquiries regarding the ability to support MT527 messaging and anticipate seeing more clients adopting 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 instruction.

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 our 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 vs. that which is held at a tri-party agent1 Tri-party agents act as an independent collateral agent to manage the collateral lifecycle.

What should clients do to prepare?

It is never too early to start preparing to be compliant with the forthcoming phases. 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

For more information, please contact your relationship manager.

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Brown Brothers Harriman & Co. (“BBH”) may be used as a generic term to reference the company as a whole and/or its various subsidiaries generally. This material and any products or services may be issued or provided in multiple jurisdictions by duly authorized and regulated subsidiaries.This material is for general information and reference purposes only and does not constitute legal, tax or investment advice and is not intended as an offer to sell, or a solicitation to buy securities, services or investment products. Any reference to tax matters is not intended to be used, and may not be used, for purposes of avoiding penalties under the U.S. Internal Revenue Code, or other applicable tax regimes, or for promotion, marketing or recommendation to third parties. All information has been obtained from sources believed to be reliable, but accuracy is not guaranteed, and reliance should not be placed on the information presented. This material may not be reproduced, copied or transmitted, or any of the content disclosed to third parties, without the permission of BBH. Pursuant to information regarding the provision of applicable services or products by BBH, please note the following: Brown Brothers Harriman Fund Administration Services (Ireland) Limited and Brown Brothers Harriman Trustee Services (Ireland) Limited are regulated by the Central Bank of Ireland Brown Brothers Harriman Investor Services Limited is authorised and regulated by the Financial Conduct Authority Brown Brothers Harriman (Luxembourg) S.C.A is regulated by the Commission de Surveillance du Secteur Financier All trademarks and service marks included are the property of BBH or their respective owners. © Brown Brothers Harriman & Co. 2019. All rights reserved IS-04815-2019-02-25

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1 In some jurisdictions, BBH may be required by applicable law to maintain collateral in custody.