September 1 was the “go live” date for phase 5 of the Uncleared Margin Rules (UMR), bringing firms with an aggregated average notional amount (AANA) of €/$50 billion into the UMR fold. Yet, instead of being a finish line that the market can move on from, it may be the start of larger challenges for the market.
Beginning in 2016, phases one through four impacted the largest dealers first and then the largest hedge funds. Phases five and six have often been seen as the most significant due to the sheer number of funds and institutional investors potentially caught by the AANA calculation, with the threshold falling to €/$8 billion in September 2022.
While the broader strategic impacts of UMR on “front-end” trading behaviors are not totally clear, we have already seen some trends within clearing for foreign exchange (FX) which may in part be driven by UMR pressures. An increasing number of market participants are embracing listed FX futures and options (the number of large open interest positions held by customers in CME FX futures is up 17% year on year), gaining diversified liquidity and capital efficiencies in the process.
“UMR has helped create a growing appetite to trade listed FX products, especially via block markets, which offer additional liquidity that is more synonymous to the existing OTC market, says Lee Spicer, Global Head of High Touch Execution at BNP Paribas. “Blocks of FX futures and options as a mechanism for accessing clearing using an OTC trading mechanism is especially strong from institutional asset manager customers.”
Potential Catalysts for Change
Once caught by UMR, there are several actions each entity will need to take. These include the following:
· New Credit Support Annex (CSA) with each bilateral counterpart, setting up a custodial account for the two-way posting of initial margin (IM), and implementing the ISDA SIMM model to enable IM calculation.
· Daily calculation, reconciliation, and dispute resolution of IM requirements. Funding, posting, and optimizing any IM over and above the minimum transfer amount (MTA).
Under UMR, the IM requirement for impacted entities exempts products such as deliverable forwards and FX swaps, which leaves a focus on uncleared interest rate products (swaps and swaptions), equity swaps, non-deliverable forwards (NDFs), and FX options. Of all these, FX options stand out as a potential source of higher IM requirements – both because of how ISDA SIMM works and because the products most used for a delta hedge (forwards and spot) are excluded from the regulatory requirement.
“The dialogue we’re having with our institutional investor base around cleared solutions to help manage UMR obligations is evolving rapidly,” says Richard Condon, Head of Hedge Fund Sales at Morgan Stanley. “FX blocks and EFRPs specifically present an opportunity to pair dynamic OTC execution strategies along with high quality market making, and then wrapping that result in a cleared product.”
An Outsized Impact on Real Money Accounts?
Phase 5, which ISDA estimates to impact around 300 entities, is likely to impact a large number of real money accounts ‒ the asset managers and pension funds who typically run large, directional books, but who have never posted any IM and typically have never used a prime broker (PB), given the inherent concentration on one bilateral counterparty.
Partly as a result of UMR pressures, we have seen an increase of 33.8% from end user customers in our listed FX options by the end of August 2021 vs. the same period in 2020. These options provide margin and capital efficiencies through the netting of all positions against a highly regulated CCP and the ability to easily include delta hedges, as well as model differences for the IM calculation.
On the other side of the equation, hedge funds are arguably well positioned to help manage and optimize the ongoing impacts of UMR. They are well accustomed to posting an independent amount (IA) or IM on their positions and typically use a PB, who can not only net all of their positions together but who may also be able to utilize IM models that enable margin optimization techniques such as consolidating FX forwards back alongside FX options.
“Given the impacts of UMR, we believe the growth trend in listed FX futures and options will continue, and that the increased usage of EFRPs and blocks for asset managers in particular are a logical part of that trend given their similarities to trading in the OTC market,” says Chris Callender, head of FX futures sales and trading at Societe Generale.
A Need to Adapt
Of all the market participants, real money accounts may face the greatest obstacles in dealing with the impacts of UMR over the coming months. A combination of a lack of familiarity in managing and posting IM, the counterparty credit concerns with consolidating risk with one bilateral counterparty as a PB, and the typically directional nature of trading could all result in increased costs and a need to adapt trading behaviors.
These potential challenges may help explain the recent uptick we have seen in use of listed FX options and emerging market (NDF) FX futures as cleared alternatives that are exempt from UMR – not only removing the human capital cost of the daily processes but also optimizing the funding cost of IM by having everything netted against a highly regulated central counterparty.
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