Life on the margins
The moment of truth has finally arrived. Beginning on 1 September, entities with the largest derivatives exposures began exchanging both initial margin (IM) and variation margin (VM) on noncleared derivatives trades; posting of IM will be progressively phased in until 2020 (in decreasing levels of derivative exposure), while all participants will be required to post VM starting on 1 March 2017.
Not only will the rollout last a full four years, but regional nuances regarding acceptable collateral, transactions included under IM/VM as well as entities deemed exempt could make the onboarding process that much trickier. Still, in the early stages participants seemed up to the task: on the day the new regime went live, Japan, Canada and the US were already posting both IM and VM. According to Diven Chatrath, EMEA head of middle office outsourcing for SS&C GlobeOp, a provider of fund administration and financial-technology products and services, it was a good day on many counts.
“The first of September marked the first day that the buy side submitted trades and had a consistent calculation across different sell-side banks, all using the ISDA’s Standard Initial Margin Model,” says Chatrath. “The bottom line is that this is promoting a very good standard, whereby both sell-side and buy-side firms are equally responsible for knowing that the information being reported is good, accurate and sensible.”
And, unlike eight years ago when an era of unbridled opacity brought the financial world to its knees, says Chatrath, “this time participants have the metrics to properly measure and manage, should another significant downturn occur”.
The arrival of bilateral margin requirements has served as a tailwind for clearing volumes of eligible OTC derivatives, remarks Daniel Maguire, global head of rates and FX derivatives, LCH. The company’s ForexClear service continues to see significant growth – including a record $152bn in FX nondeliverable forwards in August – as has SwapClear, LCH’s interest-rate derivatives clearing service.
“There has been a tremendous rise in the number of market participants on-boarding and commencing clearing, and current members and their clients are clearing a larger proportion of their trades,” says Maguire. “We anticipate this trend will continue to be driven by these regulations, other pending capital and liquidity requirements, as well as the European mandate for clearing interest rate derivatives. As such, LCH will continue to work with its members to assist with transitioning to the new regulatory framework.”
Help for the buy side
While the staggered implementation
approach is intended to allow dealers
and large active derivatives users to
set the pace for the rest of the industry,
smaller buy-side organisations that
only dabble in derivatives and pledge
nominal amounts of margin may find
it challenging to wade through the
myriad compliance, oversight and legal
nuances, especially if they don’t have a
dedicated derivatives specialist to turn to
for assistance.
“There may be a few people in-house whose job is to periodically keep tabs of derivatives activity, and suddenly they’re being called upon to determine their organisation’s legal status, register with regulators as well as ensure they have all the proper documentation in place,” says Jud Baker, product manager for derivatives and collateral management at Northern Trust in Chicago.
“It’s a concern for these organisations, which may have to engage in legal negotiations with their dealers, who themselves only have a limited number of lawyers to call upon.”
Fortunately, there are a wealth of tools that allow dealers to coordinate with their counterparties on the buy side in order to help them amend documents, calculate exposures as well as ensure adequate collateralisation. Even so, the new margining rules represent a significant operational burden for a number of players, who may ultimately benefit from a third-party intermediary.
“For instance, there are numerous providers that offer software solutions for helping firms comply with the new regulations, either through the cloud or on an installed basis,” says Baker. “Or if a company would rather avoid the integration costs altogether or keep its staff from getting involved, it may elect to completely outsource the responsibilities – which is where a custodian can come in and take over on behalf of the client.”
Northern Trust has witnessed an uptick in outsourced activity in recent years, particularly as the industry continues to evolve and regulation becomes more pervasive. “In general, larger firms have tended to stay on top of collateralisation and maintain streamlined processes,” says Baker. “However, even these companies sometimes reach a tipping point where they’ve grown tired of ticking all these extra boxes and keeping staff tied up, and therefore eventually decide to outsource, or at least seek a more efficient platform.”
Collateral call
The goal of any operation should be
to ensure that the front office is free to
trade however it wants, concurs Ted
Leveroni, chief commercial officer,
GlobalCollateral. “Without the requisite
level of collateral, trading may have to be
altered and that is a situation that should
be avoided,” says Leveroni.
“The way to prevent that is to streamline operations to the point that you are able to mobilise enough collateral to support increased call volumes. You also have to ensure that you can source the collateral effectively and use it more efficiently. Having to tell a portfolio manager who has traded a large number of derivatives that there isn’t sufficient liquidity to cover it will be viewed negatively. So not only is there an operational aspect to this, but a liquidity factor as well. And they go hand in hand.”
In order to protect themselves in both respects, clients need to take a broader look at their total collateral obligations. “Because there is more collateral required now, which necessitates greater visibility into one’s collateral pools, firms are looking to further automate and streamline their collateral processes,” says Leveroni.
“Collateral movement is part of a lifecycle that begins with the execution of a trade – therefore, timing issues upstream resulting from a lack of automation can dramatically impact the collateral process. Similarly, increased volumes, along with reduced settlement times, have put greater emphasis on automation downstream as well.”
While both buy-side and sell-side firms have, in general, been diligent about preparing for this latest round of regulations, some came into it better equipped than others. “There are companies that already had some degree of automation in place which ostensibly makes the transition much smoother,” says Leveroni.
“What’s a little surprising is that there are some larger firms whose upstream processes and timings are posing a challenge to their compliance effort. While previously the timing and automation of those didn’t matter as much – they now find themselves having to play catchup while other firms with much less complex operations are ready to go.”
Leveroni has also seen an enormous amount of collaboration among industry associations on both sides of the Atlantic, from the Securities Industry and Financial Markets Association (SIFMA) in the US to the European Securities and Markets Authority (ESMA). “Particularly over the past six months these groups have worked tirelessly to define what needs to be accomplished in order to bring the industry up to speed,” observes Leveroni.
From a product standpoint, not only have traditional vendors upped their game, but there’s also been significant cooperation between utilities, quasiutilities as well as community-based solutions that didn’t previously exist to manage collateral.
“Not only is it out of necessity, but there’s also an understanding that the collateral and derivatives lifecycle has changed tremendously over the years and now spans many different entities, each with their own set of linkages and standards covering custodian banks, clearing banks, CCPs and other counterparties. Firms leveraging community-based standards and solutions are better equipped to accurately track and process collateral efficiently.”
Taking the long view
For companies chagrined by the arrival
of yet another major regulatory hurdle,
taking the long view may be helpful,
asserts Jon Anderson, global head of
middle office outsourcing for SS&C
GlobeOp. “While it may seem like an
unreasonable amount of regulation
coming from many different directions
all at once, the reality is that this
conversation began back in 2008 with
the realisation that further transparency
into the derivatives market was needed
in order to avoid another financial
crisis,” says Anderson. “So from that
perspective, we really have moved in a
very steady manner.”
There is the premise that if you know your trade, you also need to know the extent of your exposures, whether it be buy-side to sell-side, one sell-side firm to another, in order to help quantify systemic risk within the system, says Anderson.
“So while there has been some frustration resulting from the extra time and effort around the new margining rules, as a company we are able to help firms reduce their workload using tools that can facilitate management oversight, thereby allowing companies to know where their exposures are and whether the data they’re reporting is accurate.”
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