Preparedness levels for Phases 5 and 6 of Uncleared Margin Reform (UMR) are a mixed bag. Some clients in Phase 5 completed the calculations and SIMM assessments early last year, have engaged with industry-wide testing of SIMM calculations, and are in good shape. Other firms still haven’t figured out their architecture, selected their calculation partners or got their operational systems in place. Phase 6 firms come into scope September 1, 2022, and some are ahead of the curve and are already very prepared, but the bulk of firms are leaving their preparations until January next year. Some buy-side firms are hoping for further relief from the regulators but there is no evidence that is forthcoming.
Compliance – the first focus for UMR
It is unclear how rigorously the UMR regulations will be enforced but all firms want to avoid any potential regulatory breaches. Firms have to make sure they solve their compliance requirement, and this may look different to a Phase 5 or 6 firm.
Phase 5 firms are larger derivatives trading firms that will mostly be expecting to post collateral over the $50 million threshold in some or all of their agreements. They have to set up custodians and segregated accounts, ensure the operational ability to call as well as post margin and receive collateral and paper new contracts with counterparties.
There is a lot of preparation and operational work to be done as well as the infrastructure requirements of putting in place margin calculation systems and ensuring collateral management technology is updated to process the new regulations.
The steps firms need to take are well understood and many Phase 5 firms have done the work already, but others are late to the game and are taking shortcuts. Some are electing to use the UMR grid model over SIMM margining on their portfolios, and some are even resorting to spreadsheets because they are too late to put in the necessary technology infrastructure.
The regulations only require firms to have an approved margin calculation, and these shortcuts enable firms to meet the minimum requirements of the regulation and to ensure compliance by the deadline.
However, UMR brings collateral risks and costs and there is a strong business case for moving to a more strategic operating model when time and budget allow. A simple grid model may cost less than SIMM to implement initially because of the lower infrastructure cost but may come with a higher margin and collateral requirement and thus higher trading costs in the long run. Indeed, there are examples of Phase 4 firms who started in lightweight mode and are now looking for a more strategic solution after a couple of years.
Controls – using controls to manage risk
Under UMR, firms are required to post collateral according to whichever margin model they have used. If they are unprepared and cannot post collateral, they cannot trade. The primary trading risk around UMR therefore is an inability to trade the portfolio or trade the hedges the firm needs for their overall investment mandate. This is the key risk front-office traders and portfolio managers are concerned about; they want to ensure there is no friction to their trading. The second risk is that they can trade, but it costs a lot of money in terms of financing the cost of collateral. Cost and risk are interrelated.
Firms need to know the collateral requirements of their trades on a post-trade basis and whether they have sufficient collateral to meet them. Pre-trade and intraday monitoring provides transparency on the margin requirement and impact of any trade. If there is a choice of execution counterparties, firms need to look at the relative impact of executing with each. A specific trade could have a large margin increase or be margin reducing, or even have zero margin impact if they trade under an agreement that is below the posting threshold.
Firms also need to think about collateral impact. The margin impact between two or three different counterparties may be similar but the eligible collateral they have that falls within the constraints under that collateral schedule may differ. Firms are putting in place pre-trade transparency on margin impact and collateral liquidity, and post-trade impacts to ensure that unwinds and other post-trade effects are controlled.
Phase 6 firms on the other hand are mostly going to be able to stay under the $50 million posting threshold. Their risk is actually higher, because if they accidentally go over the threshold, they will need to start posting collateral and will not have the necessary operational infrastructure in place to do so. They need a pre-execution mechanism that will block any trade that would exceed the posting threshold and force the trader to execute through a different counterparty where they can stay under the threshold. If they don’t have the infrastructure to post collateral and accidentally breach the threshold, they will have to stop trading with that counterparty and unwind to get beneath the threshold again.
Costs – active management of the cost of collateral
Any collateral that is posted has a carry cost associated with it. In bilateral trading, the cost of collateral is the primary trading cost. If a firm does not have a large pool of high-quality liquid assets (HQLA), they may have to resort to repo, collateral transformation trades or use cash to collateralize their trades, which is very expensive and has a direct impact on the portfolio P&L. Therefore, the same controls that remove trading friction, prevent trades from being blocked and keep firms compliant also factor into managing costs.
Say a firm has a choice of executing between three different counterparties and there is a similar margin impact for each, and the firm has liquid collateral for each, but the collateral they have to utilize for each counterparty has different funding costs. Factor that against the execution spread and one trade may turn out to be a lot more expensive than the alternatives. Firms need to deliver best execution under Markets in Financial Instruments Directive (MiFID) II as well as ensure they maintain regulatory compliance under UMR.
New types of cost controls are surfacing. Some firms are starting to put in place processes and tools to compare the costs of bilateral and cleared trading, for example. Other firms are trialing or putting in place UMR novation tools where firms can look at risk offsetting trades and identify trades that make sense between counterparties. This benefits both counterparties as both have the same cost exposure.
Attribution of costs to trades and portfolios is another important control—something firms already have in place for their cleared and Exchange-traded derivatives (ETD) business. Say a firm has a street facing counterparty and has an overall set of trades held against them. Those trades can often come from different desks and different portfolios. Figuring out how to attribute the use of capital and the cost of carry to those individual trades and portfolios is very important for managing cost and knowing where the drivers of costs are coming from. Several clients who use those tools within their cleared and ETD businesses are looking at putting the same infrastructure in place for their bilateral business.
Strategy – moving towards an integrated infrastructure
Whether firms build their tools inhouse or buy from a vendor, they need to make sure they have the necessary operational infrastructure in place. This includes a front-to-back analytics solution that can bring back-office data in terms of collateral and margin into the front office in a clear, transparent way and make it available at the right points in the trade lifecycle. This includes pre-trade checks, front-office reports, attribution of margin and collateral back to front-office portfolios.
Firms that are only trying to solve for the compliance piece of the puzzle and just have an end of day margin and collateral process are going to have problems down the line if they do not have the transparency and the handle on costs and the controls up front.
From a competitiveness standpoint, investors are starting to look at firms’ operational infrastructure and best execution as part of their due diligence for investment mandates when bringing in new investments. While not at the stage of being a competitive advantage per se, investors are increasingly looking to ensure firms can manage regulatory compliance, collateral efficiency, and best execution.