The G-20 mandates are the gift that keeps on giving. Initial Margin (IM) is the latest installment in regulations aimed at reducing risk in OTC derivatives trading and are proving to be a significant operational and technology challenge for market participants. IM applies to market participants globally, with up to 15 jurisdictions worldwide slated to implement Initial Margin by this year (2019).
Essentially, the regulations require counterparties to post a new category of collateral up front — hence the name initial margin — for non-centrally cleared OTC trades; furthermore, the collateral must be held in segregated custodial accounts. Naturally, the devil is in the details.
The details for initial margin include notional amount calculations to determine if a firm is in-scope for the regulation, risk-sensitive calculations to assess the collateral percentages to be applied to the various OTC instruments on a firm-by-firm basis, and validation and backtesting of these risk models. All of this is new for market participants and will require modification to existing systems and processes, as well as new systems for margin calculations and other tasks.
Compliance with IM regulation is also triggering a flurry of legal activity since each counterparty pair (and their IM custodian) is required to negotiate a set of six new agreements covering their OTC trades.
While the regulation is coordinated among the various participating jurisdictions at a high level and even — thankfully — at a medium level, there are enough specific differences among the various local regulations to make one’s head spin. These include differences of in-scope participants, instruments and trades; collateral and haircut percentages; and, of course, the ineluctable variations in trade cycles (including T+1), settlement currencies, and time zones. As well as separate (albeit similar) legal docs for each jurisdiction.
Fun fact: In the USA, initial margin regulation is governed by six (count ‘em, 6) regulatory bodies including the CFTC and banking regulators, but also the FCA (Farm Credit Administration).
Did I mention that initial margin involves a five-year rollout, which captured some 40 large dealers and buy sides globally over the first three years (2016 – 2018), will involve perhaps 60 more firms in 2019, and is estimated by ISDA to apply to an additional 1,100 (one thousand one hundred) firms in 2020?
That’s right, the final year of the initial margin rollout will apply to 11 (eleven) times the number of firms caught up in the first four years of the rollout. And a custodian for every one (well, for every counterparty pair).
No wonder some industry voices are seeking relief by asking regulators to raise the various IM thresholds to reduce the number of firms caught up by the Phase 5 rollout in 2020. ISDA estimates that raising the notional threshold from the planned US$8 billion to US$100 billion will reduce the Phase 5 cohort by 83%. Talk about the 80-20 rule!
These industry voices warn that the sheer number of new participants in 2020 will overwhelm the industry and that trading may be disrupted until firms can become compliant.
It’s always an eye opener to see how much of an impact regulation can have on market operations.
There’s another possible scenario, though. Through governance, advance planning, and systems upgrades including STP projects and use of third-party solutions and services, market participants in the know can get compliant.
Just ask the dealers and buy sides affected by IM regulation in 2016 – 2018. Celent talked to market participants and custodians in the US, Europe, and Asia-Pacific to get their views on what it took to get compliant. Boiled down to essentials, the answer is blood, sweat, tears, and technology.
For a less hysterical view and some high-level recommendations on how to navigate the initial margin challenge, see Celent’s new report, Crunch Time for Initial Margin: Challenges and Solutions for The Uncleared Margin Rules.