Changing market rules for non-centrally cleared derivatives
In a near future, initial margin will become a new market practice for many market participants. It is being implemented progressively, based on the aggregate average notional amount (AANA) of non-centrally cleared derivatives.
Which counterparties are concerned?
As of May 2018, in practice, only counterparties with an amount of non-cleared derivatives above EUR 2,250 billion are impacted. Today, they are 28 across the world but, as shown below, the threshold, dropping from EUR 2,250bn today to EUR 8bn in September 2020, many more financial institutions including sell-side and buy-side, will be affected by this regulation.
Which non-cleared derivatives transactions?
The scope of the transactions, which are taken into account in the threshold calculation, is somehow coherent across the main jurisdictions in Europe, Asia Pacific and the US. For example, physically settled forex forwards and swaps are now excluded across all jurisdictions. However, some countries (such as Hong Kong for equity options) may have temporary exemptions.
However by 2020, a large number of 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. In addition they will have to implement a specific framework to be compliant with the new rule.
Designing new business models
Variation margin requirements were implemented progressively over the last decade, which allowed time for market participants to accommodate to a new regime. In contrast, the implementation of initial margin will take place over a much short period of time. Additionally, initial margin is quite a new concept for many firms, especially for the buy-side.
How to calculate the initial margin?
The calculation of initial margin needs to follow specific calculation methodologies, either table-based methodology or the newly defined “Standard Initial Margin Method”, now known as “SIMM”
- First, the calculation relies on risk factors which need to be sourced from appropriate data sources
- When calculating the initial margin requirements, firms have to make sure the model is sufficiently scalable and subject to periodic stress tests / back tests
- In many jurisdictions (such as the European Union), firms have to be licensed by the International Swaps and Derivatives Association (ISDA) -even if they rely on a third party provider- to be authorised to use the SIMM
What are the new processes to manage the initial margin?
The challenge is not limited to the initial margin calculation by itself. A certain number of new processes have to be implemented:
• Portfolios have to be matched and reconciled in a dedicated market utility (AcadiaSoft Exposure Manager), which again requires IT adaptations and operational training and expertise.
• Conceptually, the margining process for initial margin is quite similar to the variation margin but it cannot be replicate as such:
- Initial margin is exchanged between parties. With the new rules, it is a two-way gross margining process, which means that each party needs to transfer collateral from both the pledger and pledgee’ perspective
- Parties have to determine, with each of their counterparties, the minimum transfer amounts (MTAs), the initial margin thresholds, the eligible collateral and haircuts. These elements have to be provided to their custodians
- For each of their counterparties, they also have to allocate the minimum transfer amount between initial margin and variation margin- with potential repapering impacts on their current ISDA documentation-.
What is the pledge of the initial margin?
And the obstacle course is not yet finished! Since the initial margin needs to be pledged in favour of the counterparty, a specific custody framework has to be implemented. The new framework is based on a dedicated account control agreement (ACA) signed between the parties and a custodian. The custodian can be either a tri-party party agent or a third party custodian.
Each party has to perform its own assessment to identify the best set up but also to ensure the selected custodian has a compliant framework. The custodian must check a number of boxes and ensure full protection of collateral with:
- The appropriate pledge mechanisms
- A bankruptcy-remote legal framework based on an ACA, in line with the latest margin requirements and supported by an external legal opinion
- An enforceable default process that satisfies both counterparties.
Anticipating the changes
It is urgent that firms anticipate all those changes since implementing the initial margin framework is not only about building connectivity and procedures. It will take time to implement and market participants that have not started the implementation may be too late to meet the deadline. Additionally, custodians and service providers may not have sufficient bandwidth to onboard every firm. The experience of the March 2017 deadline showed that latecomers struggled to find a solution on time and were penalised to the point of not being able to trade for a while
When looking at different set ups, firms need to assess the cost of implementing their own operational and technical capacity, compared to an outsourcing solution where they can rely on a third party provider to support compliance with the new rules. The challenge of selecting a third-party provider is to identify who can offer the best combination between calculations, collateral management and custody services. In addition, since initial margin is coupled with the variation margin process, the impact of implementing a new set up needs to be considered in the light of the current variation margin framework.
- First, the initial margin is “two-ways”, i.e. each party must at the same time posts and receives collateral with its counterparties
- Second, the initial margin needs to be calculated as per specific methodologies: table-based model or ISDA Standard Initial Margin Method (SIMM)
- Third, the initial margin 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
- The collateral cannot be re-used 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.
Simple solution to complex issues
Effective initial margin management is essential. BNP Paribas Securities Services can help market participants to address their collateral challenges, by offering a wide array of solutions including
- Calculation of initial margin, including the SIMM
- Connectivity to market utilities
- Margining services across initial margin and variation margin
- Secured and compliant custody framework.
European Market Infrastructure (EMIR) - regulation memo - here
Welcome to the tri-party - here
The collateral management challenge in Europe - here