Despite the impact of COVID-19, in-scope firms pulled together effectively over the last 12 months for phase 5 of UMR, but this has not been without its challenges...
The Uncleared Margin Rules (UMR) represent a major change in the industry as this regulation aims to bring greater stability and transparency to the over-the-counter (OTC) derivatives market. UMR affects the trading of non-centrally cleared OTC derivatives and the future of collateral management. This regulation is so extensive that it has been carried out over several years in different phases. The first phase went live in 2016 and the final phase (phase 6) is set for next year.
Asset managers, pension funds and insurance companies are scheduled to come in-scope of UMR based on their volume thresholds either with phase 5, which came into effect in September 2021, or phase 6, which will come into effect in September 2022.
UMR phases 5 and 6 will introduce more and more buy-side firms to the world of regulatory initial margin (IM), which takes the form of collateral posted to help reduce risk to a given counterparty. UMR IM requirements seek to establish international standards for non-centrally cleared derivatives.
On 1 September 2021, under phase 5, buy-side firms of all sizes had to effectively manage and optimise their liquidity and collateral needs with the right solutions and technology in place.
These deadlines were initially set for a year prior, but in April 2020 the Basel Committee on Banking Supervision and the International Organization of Securities Commissions agreed to extend the deadline for completing the two final implementation phases of the margin requirements for non-centrally cleared derivatives by one year.
The deferral came in response to the worldwide market disruption brought on by COVID-19.
In the main, the delay was welcomed by industry participants as it allowed the financial industry to focus on its clients during the volatility of the pandemic.
But with this extra time afforded, did industry participants experience a smooth transition for phase 5?
The UMR phase 5 transition
Bearing in mind the impact of COVID-19, in-scope firms, custodians and vendors that are involved in the front-to-back changes generally pulled together effectively over the last 12 months for phase 5.
The lead up to the start of UMR phase 5 was intensive for in-scope parties. The move also marked the biggest phase so far in terms of newly in-scope firms. Nearly all of those new firms are buy-side with limited previous experience of IM, and experts say this means there has been a steep learning curve for those involved.
The model laid out by phase 1, 2, 3 and 4 parties made the transition smoother than it would have been if there had not been such a well-established precedent.
For example, Hazeltree, a provider of integrated treasury management and portfolio finance solutions for investment managers, spent years developing a collateral product that allows clients to operate within the frame of UMR in the same model as a tier 1 broker-dealer, while still focusing on the unique needs of the buy-side.
“The ability to calculate according to any of the three industry standard margin approaches, calculate required value (RQV) for tri-party accounts, and expanded functionality for IM credit support annexes (CSAs) are just a few of the important features that have made this transition smooth for Hazeltree clients,” says Joseph Spiro, director of product management, collateral management, Hazeltree.
Meanwhile, Margin Tonic, a specialist consultancy that simplifies and accelerates high-quality change within collateral and related domains, has been working with a variety of firms for phase 5 go-live, including buy-side firms, their administrators and multiple custodians.
Weighing in on whether it has been a smooth transition, Mark Demo, head of community development, Acadia, comments: “It has not been without issue but, given the scale of clients that we had to onboard this year (which was more than four times the sum of the prior years), we would say that phase 5 was a smashing success for Acadia!”
However, not all participants were quite so optimistic last year when a State Street survey from September 2020 revealed 81 per cent of asset management firms were unprepared to comply with UMR despite the deadline extensions. Preparedness was measured by the perceptions, plans and readiness of 300 asset managers and allocators in 16 countries.
Of those surveyed, 86 per cent were preparing for either a phase 5 or phase 6 deadline. Only 19 per cent of firms in the preparation stage cited they were fully prepared for compliance. Almost 80 per cent of firms stated they were struggling to agree on an approach regarding how to settle segregated collateral with counterparties. Those that had agreed generally chose third-party custody with account control agreements.
“Those firms that have had the smoothest go-live so far are those that have used the one year COVID-19 delay the most productively. The firms that kept their IM readiness moving forwards over this period are now reaping the rewards with a smoother go-live,” says Chris Watts, co-founder and director at Margin Tonic.
Although some firms did not take their feet off the gas, there is a feeling that plenty of in-scope phase 5 firms — both buy-sides and dealers — put their tools down when the one-year delay was confirmed. Watts observes that these firms have been caught up in the inevitable queues at custodians, vendors and legal teams and found it more difficult to deliver the right changes. Outcomes here often include tactical, temporary solutions, which may unnecessarily increase costs, operational risk and still need future remediation.
According to Watts, the reality is that go-live success will still play out across coming months, as standard initial margin model (SIMM)/Grid exposure (referring to calculation methodologies for initial margin) grows, firms breach thresholds and then settle collateral at the custodian accounts. Only then will firms see their end-to-end solutions working successfully.
The main challenges
There have been many challenges associated with UMR compliance. One of the important nuances of the phase 5 UMR transition, which was not as prevalent in the earlier phases, is the new IM CSA term.
This defines how Reg IM under UMR will be treated when the buy-side party is already subject to a house independent amount (IA) requirement.
Spiro explains: “Since this term is negotiated in each IM CSA separately, a phase 5 firm could have all three approaches included within different agreements among their counterparties. Depending on which approach is chosen for each agreement, the daily margin call calculation can vary significantly, adding a layer of complexity that did not exist before.”
Another challenge is the communication of collateral movements to custodians. While many buy-side parties are familiar with the third-party custody model, the tri-party model utilised by dealers since UMR phase 1 is much less familiar. Even if a phase 5 firm chooses to use a third-party account rather than a tri-party account, they will still have to confirm the tri-party RQV to the tri-party custodian for the dealer’s collateral posting to work. According to Spiro, this is another nuance that may not have been obvious to some phase 5 firms.
Given that there is so much to know about this process that is completely new to a buy-side firm, and firms do not get extra credit for going at it alone, industry participants believe it really pays off to work with someone who specialises in Reg IM compliance. This is also because the volumes are so much greater than in any phase prior so firms can be in trouble if they delay.
“It is why Acadia offers the ability to go-live in its production environment — monitoring, calculating and reconciling well before a firm’s go-live compliance date. There should be no surprises,” says Demo.
From Margin Tonic’s perspective, Watts comments: “Being on the ground with IM since before phase 1, we have seen a lot of challenges! IM readiness has evolved over that time.”
One of the key challenges Watts sees for phase 6 is the scale of change. He notes: “Almost all newly in-scope firms underestimate the IM solutions they will need to deliver. There is genuine front-to-back change required across risk, operations, treasury and legal for those firms who expect to breach threshold and exchange collateral.”
It is therefore important for firms to understand their compliance scope now and then accelerate the delivery of those changes, by choosing the right solutions for each part of their process flow.
Additionally, ‘beating the queues’ is another challenge associated with phase 6. This is as the International Swaps and Derivatives Association estimates almost 800 new firms will be caught in-scope in phase 6.
“The industry queues we have already seen in phase 5 will become far longer and more painful. Firms need to do all they can to ensure they are ready with their new IM operating model as early as possible, avoiding the worst parts of those queues and therefore ensuring no trading impact, which is a critical goal for all,” Watts affirms.
He adds: “The combination of a high scale of change and the industry queues to come is not a great one…”
New firms need to ensure they clearly understand the IM rules and changes, in order to quickly make the right solution decisions and get a headstart on the industry queues.
However, Watts explains internal education is often a challenge for latter phase firms, with limited internal IM experience, key teams often working in their own silos and competing priorities.
According to Watts, phase 6 firms should leverage external expertise to accelerate internal knowledge and decision-making where they have gaps, either via the likes of Margin Tonic or vendor partners who have had deep experience of previous phases.
No gain without pain
Industry participants have worked extremely hard to comply with UMR, and all of the hard work and challenges have not been in vain. Demo points out that the ability to delay operational readiness is a great financial benefit to firms who will not exceed their Reg IM threshold on the compliance data. It does, however, create a need for solutions such as Acadia’s IM Threshold Monitor service. This service enables in-scope firms to see the Reg IM exposure and threshold that their dealer counterparties calculate before go-live and without cost to them.
Meanwhile, UMR is also an opportunity for firms to update their manual processes with new, enhanced technology. Spiro cites: “As operational processes become more complex, to avoid any regulatory breach, buy-side firms may take the opportunity to automate some of their manual processes, which can make them even more efficient than they were in the pre-UMR world.”
Also discussing the opportunities UMR can provide, Watts suggests it can future-proof profits. He elaborates: “You will not find many firms with nice things to say about IM! But if we take a wider view, the main opportunity from IM is that the cost increases it brings are forcing firms to strategically re-assess their derivatives and collateral infrastructure.”
“As a result, firms are proactively finding new ways to bring their costs down, in order to future-proof profits.”
Watts explains there is a whole world of different techniques that firms can use to reduce their derivative cost base, some internal and some often via vendors.
These include but are not limited to operations outsourcing, removal of cross-product silos, single asset inventories, improved internal collateral mobilisation, increased clearing, new optimisation techniques, pre- and post-trade, among others.
“Perhaps obvious but the key for each firm is to understand their own unique circumstances and choose solutions which will have the greatest positive impact on their profits. These solutions may vary for the short-term and long-term,” Watts comments.
Upcoming changes?
AST finds that there are some parts of the UMR ruling that may cause global regulators to collectively look to tweak or change in the near future.
Demo says: “The industry does expect some level of relief from European regulators around the model validation requirements for buy-side firms who are caught up in UMR but do not have traditional quant capabilities. This would level the playing field somewhat with US regulations that place the UMR requirement squarely on the prudentially regulated entity.”
Spiro remarks: “Some aspects of the rules have been viewed by the industry as a bit inconsistent from the start. One example is that physically settled foreign exchange forwards are included within the average aggregated notional amount calculation to determine which firms are in-scope for UMR rules, but then once in scope, those same trades are not included in the SIMM calculation.”
Spiro suggests that this leaves some firms technically in-scope for the rules, and having to repaper their agreements, but with a high likelihood of never having to actually move collateral.
Another example would be the inconsistency of rules from one regulatory jurisdiction to the next; in the US, a swap dealer has an obligation to post collateral to their counterparties, but a buy-side firm does not have an obligation to collect.
In practice, Spiro explains this means that a buy-side firm has no obligation to independently calculate the SIMM requirement. Rather, they can rely on their dealer counterparty’s calculation, potentially avoiding a large expense.
Spiro adds: “This is not the case in other regulatory regimes, where both parties have an obligation to post and receive. There has been industry advocacy to try to normalise certain aspects of the rules such as these.”
With potential tweaks and changes upcoming for UMR, along with the outcome of the go-live yet still to play out fully, it is hard to say how successful the transition has been to phase 5 for the industry as a whole.
Generally, given the challenges with the pandemic, the industry has worked well during this transition period. The clear winners will be those who continued to plan and prepare during the extra time afforded and those who work collaboratively with the rest of the industry.
