On 1 September the final phase of the Uncleared Margin Rules (UMR), which requires in-scope firms to exchange initial margin for un-cleared derivatives, goes live. The final phase is the cumulation of a six year global roll-out of UMR and will lower the in-scope threshold to $8 billion average aggregate notional amount (or local market equivalent) of un-cleared derivatives. The final phase will have the broadest impact to date - with up to 800 firms expected to be in-scope, according to Acadia. In-scope firms will need to implement major changes to their existing operational processes and custodial relationships. The consequences of being unprepared are dramatic; firms that are not ready by the deadline won’t be able to trade un-cleared derivatives.
Once a firm determines that it is in scope for the final phase, it should determine which trading relationships will be included. Recognizing the potential impact on market participants, global regulators provided some measure of relief. Firms that breach the un-cleared derivative threshold but with less than $50 million (or local market equivalent) in initial margin to post per counterparty, can defer the documentation, custodial, and operational arrangements. While welcome, the relief is no panacea. As John Southgate, EMEA Head of Collateral Management at Citi Securities Services warns, “It’s not a ‘get out of jail’ free card. Firms that can take advantage of the relief still have to constantly calculate and monitor their threshold levels to make sure they are still below the $50 million sub-threshold.” In order to do so, firms still need to implement new workflows and systems to identify in-scope transactions and run regular initial margin calculations. Despite these challenges, many industry participants elect to perform threshold monitoring. In phase 5, which was the first one to impact asset managers, all 330 in-scope firms performed threshold monitoring across all or part of their portfolio and approximately 55% exchanged initial margin with an in-scope counterparty on or close 1 September 2021, according to Acadia
Coming to Grips with the Operational Challenges
Perhaps the biggest operations challenge for asset managers is calculating initial margin. “It’s a difficult exercise, and for most asset managers it’s entirely new,” says Diana Shapiro, North America Head of Collateral Management at Citi Securities Services. “Many firms will need to invest in technology or look for outsource solutions to ensure they can calculate the daily margin amounts.” In either case, this requires the development of new expertise to oversee the process. The rules also mandate that initial margin must be held in segregated accounts at an unaffiliated custodian for each counterparty relationship, which is a different model than typically used for the exchange of variation margin. In addition to the custodial arrangements, a bilateral Credit Support Annex, which governs the collateral arrangements between the trading counterparties, needs to be put in place for each counterparty relationship. All of this takes time. Based on the pervious phases, negotiating custodial agreements and other documentation requirements can take over nine months to complete and are subject to prioritization by the dealers. Firms should take this timeline into account as they prepare for September.
Another consideration is that the scale of the sixth phase may put additional strain across the industry. “With so many firms potentially in scope, there’s a real risk of a bottleneck if everyone leaves it to the last minute,” warns Karim Chabane, APAC Head of Collateral Management at Citi Securities Services. "Custodians, broker dealers, and law firms will all be dealing with multiple parties looking to get their ducks in a row.” This will put stress on resources across the industry and could lead to delays in finalizing the necessary arrangements. The sooner firms start to enact their initial margin plans, the better chance they have of avoiding any delays.
The Potential of Tri-party
Unlike the variation margin rules, under UMR both counterparties have to post collateral on the same day. The added burden of posting initial margin for the first time will require firms to access increased levels and a broader range of collateral. A potential solution for this is the use of tri-party collateral management, where both counterparties use a third-party agent to manage collateral. Tri-party arrangements were used extensively by market participants in the first four phases of the initial margin rules, as result most dealers will seek to deliver collateral via the triparty route. However, asset managers are typically less familiar with the model because traditionally most derivative margin posting is performed bilaterally.
Implementing tri-party solutions comes with its own challenges. Firms may need to establish new workflows and build connections to the tri-party provider; along with additional legal documentation, and the appointing and oversight of the tri-party provider. In addition, dependent on the firm’s assets, the cost of a tri-party model might outweigh the benefit received. Firms need to weigh the cost benefits carefully when deciding whether to use a tri-party collateral structure. As an alternative, many firms have opted for a third-party model bundled with collateral services. This option allows clients to benefit from operational automation while maintaining the simpler custody structure.
Eyes on the Prize
The last phase of the UMR requirements pose a number of operational challenges, adding to their costs at a time when margins are already being squeezed heavily. This is particularly true for smaller firms, which may deter them from using derivatives to hedge their risks. In-scope firms should be well into their preparations because the deadline will be here in no time and firms cannot afford to be unprepared.