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Initial Margin segregation: better safe than sorry
Initial Margin segregation: better safe than sorry
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Initial Margin segregation: better safe than sorry

06/12/2016

Jerome Blais

Jerome Blais

Product Development

BNP Paribas Securities Services

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How can service providers help coping with the difficulties to protect initial margin now required under new US and European regulations?

After years of discussions, analysis, developments, legal work and, yes, a few delays, the regulatory requirements linked to over-the-counter derivatives (OTCD) are upon us with, in particular, the first wave of initial margin (IM) requirement for some of the largest non-cleared swaps counterparties. Indeed, only the most active counterparties fall under the scope of the first wave of the CFTC rules and its cross-Atlantic equivalent, the European Market Infrastructure Regulation (EMIR).

In practice, only counterparties with a notional amount of non-cleared derivatives above EUR 3,000 billion will be impacted, with smaller entities falling under the scope of the rules on a gradual basis, every year, until the threshold will be lowered to EUR 8 billion. This means that ultimately, almost all non-cleared swaps counterparties, except smaller buy-side players, will have to pledge a significant amount of collateral in order to cover the regulatory requirement and they will have to implement a specific custody framework to protect this precious collateral.

Not your average exposure

The provisions related to IM come with specific rules and guidelines. First, the IM is “two-ways” i.e. each party must at the same time post and receive collateral with its counterparties. Second, the IM is pledged (and not transferred in full title) in favour of the counterparty and has to be held with a third-party custodian that is not affiliated with any of the counterparty. In addition, the collateral cannot be reused or re-hypothecated, and it has to comply with some stringent concentration and wrong way risk limitations. Last but not least, the contractual framework is based on dedicated account control agreements signed between the counterparties and the custodian.

The third party custodian must also check a number of boxes. It must ensure full protection of collateral with the appropriate pledge mechanisms, a bankruptcy-remote legal framework based on an Account Control Agreement in line with the latest margin requirements and supported by an external legal opinion, as well as an enforceable default process that satisfies both counterparties. These are among the reasons why some observers have raised doubts as to the industry’s readiness to meet the upcoming European deadline at the beginning of 2017. The first US wave of September 2016 showed that participants appreciated some custodians’ ability to quickly on-board clients with straightforward processes and much needed support.

When it comes to IM, regulators authorise firms to use a wide range of assets from cash, bonds (corporate and government) to equities from the main indexes, shares of funds, and even gold! Cash is by nature very liquid and can be quickly repatriated in case of counterparty default, but it also comes with fungibility risk. So far, the industry has clearly recognised this as a potential caveat to using cash to cover IM but it is not, per se, a blocking point.

Simple solutions to complex issues

Effective collateral management is essential. Service providers such as custodian banks that can offer to their clients a wide array of solutions including robust and highly automated systems connected to market utilities, secured credit facilities, and a platform that can facilitate the access to liquidity providers can help market participants to address their collateral challenges. Custodians can help counterparties access other types of eligible collateral by, for instance, providing cash reinvestment facilities with which swap dealers can simply post cash collateral that will then be immediately reinvested in money market funds. This process is explicitly provided for in the regulatory technical standards and is mutually beneficial as it protects both counterparties from the fungibility of cash, and it can generate return on the funds’ shares. This alternative solution may be more in demand in the near future, especially due to the regulatory requirement that forbids the re-use of collateral and the current context of negative interest rates.

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