Whether it’s a small basil plant in the kitchen, a potted plant on a balcony, or flowers in the garden, all gardeners want to see evidence of growth. Week by week the hope is to see new leaves or flowers blossoming. So just imagine the patience required to grow Chinese bamboo. With no visible growth for 4 years, everything changes in year 5, and in a matter of weeks it can grow more than 30 metres in height.
The phased-in approach of global uncleared margin rules (UMR) has been similarly slow. Since 2016 just 70 or so firms have been required to comply across 4 phases. This all changes on September 1st 2021, when the industry expects more than 300 new organisations to come into scope overnight.
Phase 5 of UMR is different to previous phases for several reasons. Not only are many more firms brought in-scope, but it also creates a large impact on the buy-side, hitherto largely out of scope. Without the large scale resources of the sell-side to hand, and with many firms needing to solve for the added complexity of managed funds, buy-side firms face their own additional hurdles to comply.
Crucially phase 5 firms have one advantage over those in earlier phases. Namely that they have been able to take advantage of regulatory relief which has allowed them to delay some of the UMR documentation preparation steps until absolutely necessary. For most, this has meant a scaled back compliance, allowing them to focus on relationships where IM exposure is expected to exceed €50m relatively quickly. And while a good number may end up delaying documentation for months or even years, a smaller number may end up completely avoiding the complex set of legal documentation required by firms in earlier phases.
However, even where firms have been able to take advantage of this regulatory relief, the baseline requirement has still required them to put in place new capabilities to calculate and monitor Initial Margin (IM). And for those who expect to quickly exchange margin, have also had to prepare by opening custodian accounts and negotiating legal documentation.
While all in-scope firms must calculate IM, how they choose to do this has been a key decision firms have had to make. Faced with a choice of calculation methodology (SIMM™ vs. schedule) firms have had to evaluate their capabilities to support each, ascertain which model aligns with their portfolios, as well as discuss the model preference with counterparties (or clients). While the ISDA SIMM™ methodology may have been the default choice in earlier phases, many phase 5 firms – particularly those with directional or vanilla portfolios, or who benefit from a large cushion below the regulatory €50m IM threshold – have been able to give greater consideration to the schedule approach, even as a potentially short-term option before moving to SIMM to gain the maximum grace period under regulatory relief.
While the relief granted by regulators to phase 5 firms stands out as an obvious differentiator to earlier phases, what we have seen in terms of system selection and technology among phase 5 firms also marks a key difference. The larger stature of phase 1-4 firms meant most were able to handle IM calculation and margin requirements in-house. In contrast, phase 5 can be characterized by a distinctive shift towards use of 3rd party providers for large parts of their UMR needs, including IM calculation. This can be explained by several factors, including a lack of internal expertise with IM models, a broader shift towards use of dedicated vendors over internal build approach, reduced delivery cost and the short window in which to implement UMR.
TriOptima has also observed a difference for phase 5 related to both monitoring & margining tools. Many phase 5 firms had previously managed collateral via legacy vendor or in-house solutions without STP, or connectivity to industry tools. UMR highlights the importance of connecting to a wider network of platforms, including both triResolve portfolio reconciliation, and Acadia’s IM Exposure Manager service. As such we’ve seen a substantial number of firms implement triResolve Margin as a key part of their UMR projects - thus helping them to prepare not only for IM calculation & exchange, but also providing the necessary industry connectivity and automation to resolve legacy issues associated with Variation Margin (VM).
And perhaps the final difference for phase 5 firms relates to the topic of dispute management. While this has been a day 1 priority for firms in earlier phases, the combination of regulatory relief and for many, a slow build-up of IM exposure that may remain below the threshold for some time, means this has not had the same level of urgency among phase 5 firms. While this may simplify their overall UMR project, firms must still determine how they will manage any differences, regardless of size.
While clients have been using our UMR solutions since phase 1, it’s fair to say that we have seen a huge jump in demand with phase 5. Fortunately, the experience we’ve built-up over 4 years has been critical to helping clients prepare ahead of the deadline.
Two key things stand-out in terms of client preparations.
Our team of triCalculate Valuation Analysts have been working with phase 5 clients since 2020 to help guide them on data requirements and to deliver IM calculations. Wherever possible we’ve focused on providing an early calculation of IM using existing live portfolios. This has worked as a fantastic way for firms to understand the potential impact of UMR, to understand how IM exposure builds up – as well as to help choose the right IM model for them - and critically to help identify those relationships that are most likely to breach the €50m threshold. This in itself is essential to determining the broader impact of a firm’s UMR project.
Once you identify which counterparties are most likely to breach the threshold you can prioritize legal document negotiation, open applicable custody accounts, and put IM dispute procedures in place. By identifying that you’re likely to breach with several counterparties, this means you will need to negotiate legal documentation, open custody accounts, and put in place both a calculation and dispute management process. Conversely, if you identify that you will likely remain below thresholds for several years, your project takes on a much lighter look & feel, allowing you to focus on IM calculation and monitoring only. The benefit of early IM calculation also means a much lower chance of surprises come September 1st!
While regulatory relief means phase 5 firms may manage their day-to-day IM operations differently - either monitoring or margining, or a combination of both – our team of triResolve Margin Client Managers have been helping firms to prepare for both approaches. This includes setup of both regulatory IM agreements and monitoring agreements, integration of data from IM exposure calculators (including triCalculate and Acadia’s IM Exposure Manager) and testing of IM workflows. For clients with 3rd party or triparty relationships, we have provided automated connectivity to their chosen custodian, including BNY Mellon, Clearstream, Euroclear and JP Morgan - thus removing the need for manual payment instruction, maximizing STP and reducing the risk of settlement failure.
Regardless of whether phase 5 clients are monitoring or margining we’ve also helped firms by transforming their broader collateral management capabilities. Nearly all in-scope firms began their preparations by first adopting triResolve Margin to automate their VM process, many doing so months (or even years!) in advance. By doing so they have been able to benefit from immediate operational benefits, including electronic connectivity to counterparties, real-time call exchange and an automated margin workflow.
With IM being calculated on new trades only, combined with regulatory relief to delay documentation, the day 1 impact for large parts of the market is reduced. While all firms should be able to calculate IM exposure on day 1, the associated operational burden of margin call exchange, dispute investigation & collateral settlement will fall on the shoulders of a smaller number of firms. With the net result being that the broader impact is felt over time rather than as a big-bang.
Hopefully, this delayed impact allows those firms who require it, the additional time to prepare documentation, complete systems implementation and develop procedures to support the end-to-end process.
Phase 5 represents the largest phase of global margin regulations to date. However, just as soon as the industry has solved the ‘Chinese bamboo’ phase, so to speak, it’s forced to begin preparing for an even larger phase 6. With up to 700 entities expected in-scope in September 2022, firms must begin preparation as soon as possible. Early decisions on IM calculation models, custodians and technology solutions are critical – and securing the necessary resources may make the difference between your phase 6 project looking more like an ornamental garden rather than a garden maze.