The cost of doing business in the over-the-counter (OTC) markets is set to soar for a significant number of buy side firms over the next two years.
As part of a G20 effort to protect counterparties against the losses of potential defaults, non-cleared OTC products, with the exception of physically settled FX swaps and forwards and some temporary exemptions, must be backed by a substantial amount of collateral.
As of September this year, counterparties with a gross notional amount of non-cleared derivatives above €1.5 trillion (£1.34 trillion) are already posting initial margin. Firms have been brought into scope since 2016 according to a threshold that is lowered each September until it reaches €8 billion in 2020, when most buy-side firms will be in play.
As opposed to a steady phase-in as intended, there will be a big spike at phase five in 2020 as it encompasses almost 10 times as many participants, as estimated by the Financial Conduct Authority based on a sample of UK firms. Experts anticipate this will be a catalyst for operational and strategic changes as those firms strive to implement the rules in an already cost-constrained environment.
Stay below the threshold
For firms that are hovering on the edge of the uncleared margin thresholds, reducing the notional amount of non-cleared derivatives in their portfolios to remain out of scope is a tempting solution.
“Firms might change their strategy to fall under the threshold, but they still need a process in place to calculate uncleared initial margin so they still need to do all of the work but might not have to post the collateral,” said Simon Millington, head of product management at Cloudmargin.
“They still need to be operationally ready, have documents in place, and they have to calculate initial margin even if on a day-to-day basis they are not using it.
“It won’t be as labour-intensive, but they still need to have the framework in place to be compliant.
“Any decisions that they make now could have an impact, and their investments need to be future-proofed,” Millington explains.
For example, if firms do decide to slash the amount of non-cleared derivatives in their portfolios, it could take some time to unwind certain positions or to clear certain trades.
Nevertheless cost saving opportunities could lie in the method counterparties use to calculate the amount of initial margin that they are required to post.
The International Swaps and Derivatives Association (Isda) developed a standardised initial margin model (SIMM) which has so far been the method of choice among dealers that are already in scope.
“The most compelling reason for firms to adopt SIMM is that the initial margin amounts will be substantively lower in most cases,” Tara Kruse, global head of Infrastructure and data at Isda, said.
The trade body’s analysis shows that for phase five firms, calculations could be two to three times higher under the alternative model - the schedule-based approach.
This is because firms that have diversified portfolios will benefit from the netting opportunities built into the SIMM.
However, those with less diversified portfolios could end up with lower initial margin amounts under the schedule-based approach, which is easier to implement and support.
“The firms will need to consider how they will support SIMM. There is preparation involved for schedule-based calculations, but it is not as extensive,” Kruse adds.
Uncleared margin rules generally require a quantitative initial margin model to be recalibrated at least annually and cover the risk at a 99% confidence level over a 10 day theoretical close-out period.
This 10 day period was disputed in April when Rama Cont, chair of mathematical finance at Imperial College London, conducted a study commissioned by Isda.
He argued that it is not realistic given that it does not take into account the liquidity characteristics of the assets, the size of the position or the fact that participants would hedge their exposure to the defaulted counterparty.
“Rama Cont’s study turned out to be a controversial paper because it dealt with some of the fundamental assumptions made in the Isda SIMM, particularly the 10 day horizon,” Hiroshi Tanase, executive director, derivatives valuations at IHS Markit, said.
“However, I am not seeing anything that would make anyone sceptical of the methodology,” he adds.
According to Tanase, the Isda SIMM will likely prove to be a viable method for all firms in scope.
“Having said that, some phase five firms (mostly hedge funds) may have very specific portfolios, and it is not 100% certain that SIMM will work for their portfolios,” he adds.
“If a portfolio contained only interest rate swaps then SIMM would certainly provide a sensible number.
“However, if you have a portfolio where the bulk of its risks are non-standard risk factors such as a correlation risk or a second order risk, the risk of the portfolio will not be accurately captured by SIMM,” he explains.
A likely scenario is that sell side firms who are already using the SIMM model will encourage buy side clients to use the same model in order to avoid a bifurcated process, but this shouldn’t pose any problems.
What firms will have to be prepared to face is the inevitable number of mismatches that will arise when initial margin numbers are reconciled. This could in practice be time consuming to resolve.
“Tracking the source of the error can be challenging due to the nature of the underlying data,” Tanase explains.
For example, if two participants are using different methods to do risk sensitivity it could give rise to different numbers.
Another common reason for mismatches is differences in trade population.
If one counterparty bases their calculation at a particular time of day, while the other counterparty bases their calculation at the end of the day, differences may arise as to whether a certain trade gets included in the portfolio or not.
“Since initial margin is based on risk, final trades could have a big impact on initial margin,” Tanase said.
Avoid additional work
Isda advises firms to disclose whether they will be in or out of scope 12-18 months before the initial margin go-live date to allow time for each counterparty to prepare.
According to Richard Barton, product manager for AcadiaSoft Agreement Manager, firms could end up taking on additional work as they try to keep track of who is in scope.
“Firms are not necessarily certain as to whether they come under the threshold,” he said.
This means some firms are having to prepare as if they are in an earlier phase and vice versa, and there could be a “sprint” to handle those situations.
“For example, when drawing up agreements, as you get to 2019 and 2020, firms could spend time working on a relationship that wasn’t needed in the end,” Barton explains.
“They instead would want to work on the ones they are certain of and then might also work on the ones that are less so.”
One of the requirements for initial margin under the uncleared margin rules is that it must be held in a segregated account and must be posted by each counterparty.
Many firms that are not yet in scope will have to open new accounts, establish relationships with custodians, disclose relevant information to the other counterparty and decide on minimum transfer amounts and initial margin thresholds.
The mass renegotiation of contracts presented a huge challenge for firms that have already been brought into scope.
However, in anticipation of the influx of participants during the next two years, vendors have been coming up with ways to automate the processes and provide interoperable tools for firms that are able to invest in the infrastructure.
“What was needed was a standard workflow that would let you choose where to work from but provide a common way to connect with counterparties when you needed to,” Barton said.
“If you can do that then the benefits are huge in terms of onboarding, dispute resolution etc.”
Managing and administering collateral in-house could also be a costly and burdensome process.
This is why a trend towards the tri-party model, typically used in repo and securities lending markets, is now gaining traction for non-cleared derivatives.
The firms in scope so far have used the tri-party segregation model and built on the tri-party repo model for collateral whereby the settlement takes place between the counterparties.
“Because a large number of dealers have used the tri-party structure thus far, it is possible that they may encourage buy side firms to use the same structure,” Amy Caruso, chief commercial officer at DTCC-Euroclear GlobalCollateral, said.
“This allows for operational efficiency when valuing the collateral, assessing the collateral using algos that the counterparties establish, and moving the collateral to the appropriate account.
“The tri-party model also allows for improved straight-through processing between valuation and selection, thus creating further operational efficiency,” she adds.
Albeit a less common option today, firms coming into scope could also opt for a third-party account structure where the pledging counterparty values and selects the collateral if it is more suited to their needs.
To clear or not to clear
According to an Isda survey on the 20 largest market participants (phase-one firms), the amount of initial margin collected for non-cleared derivatives increased by almost 22% to $130.6 billion at year-end 2017 compared to the first quarter of 2017.
Some $56.9 billion comprised discretionary initial margin posted by counterparties not currently in scope, demonstrating that the market is exceeding the regulation and clearing more than is mandated.
However, in a paper published in July, Isda and the Securities Industry and Financial Markets Association reiterated that for those that are not already posting initial margin, the race against time has started, and the costs and risks of failing to comply are enormous.
“If not done in a timely manner, newly in-scope counterparties may not be able to trade non-centrally cleared derivatives, limiting their options for both taking on and hedging risks, and also potentially impacting liquidity in the derivatives markets,” they wrote.
Those that are unable to access their OTC trading venues may need alternatives to hedge their exposures.
However, cleared products may not prove to be viable alternatives due to a lack of scope for diversification and customisation, leaving them with more risk on their own balance sheet.
Furthermore, for buy side firms the grass may not be greener at a clearing house.
For example, some CCPs may charge additional margin, such as so-called liquidity or concentration add-ons, for large positions.
Hedge funds looking to exploit price differences between two related markets, like bonds vs futures, are likely to be most impacted and they could face up to 70% additional margin costs, according to a study by margin analytics firm OpenGamma in May.
In 2014, a Deloitte study estimated the additional costs for centrally cleared OTC derivative transactions per 1 million notional amount traded would be €13.60.
The additional cost for OTC derivatives that are not centrally cleared was found to be around €170.50.
The vast cost disparity will drive important decisions as firms seek to retain the most optimal derivatives in their portfolios while facing scrutiny from investors seeking higher returns.
As more data on margin becomes available, firms will be able to establish which portfolios are consuming the most margin and work out how to optimise collateral in order to better manage their business.
Meanwhile in response to the standard setting bodies’ consultation on incentives to centrally clear OTC derivatives, trade bodies expressed mixed views about whether uncleared margin regulations will incentivise participants to clear.
On the one hand, incentives to clear are redundant if a product is not suitable for clearing.
On the other hand, liquidity tends to build where participants find it most efficient to trade, so there could be a shift away from more complex instruments to standardised products that have lower margin requirements.
What is certain is that margin requirements, introduced for the first time for many, will force participants to better internalise the cost of their risk-taking – as the G20 intended.