UMR in scope, or umr not in scope – that is the question?
Nine months may seem like a long time to prepare for phase 6 of the Uncleared Margin Rules (UMR), but if regulatory history is any guide, it is no time at all. This is particularly true for UMR where the non-compliance stakes are higher than MiFID II. Instead of a fine, fund managers will not be able to trade with counterparties if they do not meet the regulatory requirements by 1st September 2022.
The underlying jeopardy is focused on the level of certainty of knowing whether you are in scope or not. What is thought to be a simple binary answer can in fact be far more complicated. In fact, firms in phase 6 which have not started building their foundations are already lagging far behind as UMR, which involves the mandatory exchange and segregation of initial margin (IM) on non-cleared derivatives trades, is viewed as a one-year project.
For this cohort, the threshold drops to $8bn (or jurisdictional equivalent) which captures a much larger number of buy-side firms than in the other waves. Estimates from the International Swaps and Derivatives Association (ISDA) show that as many as 775 entities will be caught – which is well over double the number of entities in Phase 5.
It would appear that people aren’t understanding who owns their funds and whether or not they are in scope. Even in the last few weeks, we have had two firms urgently contact us because the more they looked at their scope analysis the less certain they were of its accuracy.
This task, however, should not be underestimated as phase 6 firms, unlike larger sell- and buy-side firms that preceded them in the first five stages, have smaller trading volumes, scarcer resources and many have only ever exchanged Independent Amounts (IA), rather than IM before. Operational and legal infrastructures will need to be overhauled but equally as important, they need a firm grasp on the inner workings of the UMR.
To make matters worse, the Phase 6 community of firms have additional challenges on top of those encountered by the first phases that have already gone live with UMR.
Knowing your AANA
A hurdle that firms first need to overcome is to determine whether they are in scope. This requires calculating the Average Notional Amount (AANA) which is the total gross notional of all outstanding non-cleared derivatives, including trades intermediated with a prime broker.
Although the rules may appear simple, understanding the product scope and position ownership can be complex for asset managers and fund owners who have majority ownership structures and definitions of a group entity are often opaque. This is a more complex issue for the buy-side, and something the sell-side has not had to deal with.
This is because asset owners typically have managed accounts where multiple managers oversee a portfolio as part of one legal entity. Uncovering which funds have derivative positions can be a complicated exercise. They must sift through the different layers to see where the derivatives are hiding which is time consuming. The nirvana would be to have a holistic view on an aggregate basis across all their portfolio managers, but many asset managers do not have this complete view to hand.
Other difficulties include consolidation of data from multiple trade sources, lack of AANA regulatory guidance and varying calculation methods across jurisdictions. In addition, trading volumes and products will change over time, which means that AANA calculations should be performed regularly and on an ongoing basis in March, April and May.
Once the AANA status is determined, firms must notify their counterparties and then prioritise the trading relationships into three buckets – those who will quickly reach the $50 million (or jurisdictional equivalent) UMR exposure threshold, at which point both parties are required to post IM, those who will eventually reach the threshold, and those that probably never will.
Asset owner vs an asset manager
Here again the issue of an asset owner vs an asset manager comes into focus. An asset manager with a mandate from the ultimate owner is trading derivative positions that are impacting the asset owner’s IM requirements under UMR. With no visibility on the full derivative position of the ultimate owner they may accidentally trade a bilateral derivative position that pushes a client over the UMR threshold, causing the asset owner to post IM because of their trading activity.
This risk can be mitigated by the allocation of portions of the UMR threshold to each asset manager represented by the ultimate asset owner, but there remains risk in this approach as an asset manager may accidentally trade a bilateral derivative position that pushes a client over the UMR threshold, causing the asset owner to post IM as a result of their trading activity.
Firms also need to agree with their counterparts the IM calculation methodology to use. There are two regulatory options – the Standard Initial Margin model (SIMM), a sensitivities-based model which participants in phases one to five have almost all favoured, and Grid, an approach based on percentage of notional. To date, SIMM is the preferred choice for most firms captured by UMR.
Compliance, Controls and Cost
Despite the many moving parts, they can be at the starting gate by 1st September 2022 if they implement a solution that addresses all the three C’s: Compliance, Controls and Cost.
Compliance is being able to calculate and monitor regulatory IM and post and receive the appropriate collateral. Controls is implementing solutions that provide transparency and forecasting to proactively control margin and collateral levels. Finally, Costs, which is identifying margin offsets and understanding carry cost as a part of overall trade cost.
Blending all three Cs together requires the expertise to navigate the maze of UMR as well as the requisite infrastructure that can handle pre-trade checks, AANA monitoring, front-office reports, attribution of margin and collateral back to front-office portfolios.
Although the ANNA and IM computations may be thorny, the dangers of not complying are straightforward – firms will not be able to do business. There will be no excuses, which is why it is imperative that firms have a full grasp of what is required and a clear view of derivative positions across their portfolios, in time to be fully compliant and allow them to continue trading.
