A welcome delay
In July 2019, the Basel Committee and the International Organization of Securities Commissions (IOSCO) agreed to a one-year extension to the final implementation phase of the initial margin requirements for derivatives contracts that are not cleared through a central counterparty. These requirements are designed to reduce systemic risks related to over-the-counter derivatives markets, as well as provide financial institutions with appropriate incentives for central clearing while managing the overall liquidity impact of the requirements.
Under this extension, covered entities with an aggregate average notional amount of non-centrally cleared derivatives that is greater than EUR 8 billion (phase six firms), become subject to the requirements from 1 September 2021. Meanwhile, the 1 September 2020 deadline remains for phase five firms, but with a threshold increased to EUR 50 billion.
David Beatrix, Head of Product – Collateral Access at BNP Paribas Securities Services, describes these delays as a sensible response to concerns that firms, especially buy-side ones, were not prepared for the impact of the new rules.
“At the root of this reform is a desire to move from a ‘survivor pays’ principle, to a ‘defaulter pays’ principle, to avoid firms using their own capital to absorb losses implied by a counterparty bankruptcy. Another effect is that this will also promote central clearing,”
“There is a realisation on the part of the Basel Committee and IOSCO that initial margin [IM] compliance is not just a copy-and-paste of the variation margin [VM] process; it is a new process with a steep learning curve.”
The margin requirements for non-centrally cleared derivatives are broadly aligned across North America, Europe and Asia Pacific, although there are nuances with regard to exemptions. For example, equity options are out of the scope of margin requirements in the US rules, but were only exempted in the European Union up until 4 January 2020.
Among the buy-side community, asset owner institutions (particularly insurance companies, pension schemes and sovereign wealth funds) are expected to be most affected by the changes because of the size of their derivatives positions and their consolidation under one single entity, says Beatrix. Asset managers will only be impacted if they have delegated mandates from asset owners or if they manage funds that use over-the-counter derivatives above the EUR 8 billion threshold, which remains rare.
Furthermore, when asset owners delegate the management of their assets – usually across multiple managers – they also often delegate middle and back office functions. This can make it challenging to calculate initial margin due to the potential for fragmented calculations across multiple managers.
“We have already had discussions on this topic with clients who are tempted to replicate what they already do on variation margin – in other words, to leave their investment managers to manage the variation margin independently from each other,”
“This works well for variation margin because numbers are additive, but initial margin is a risk-based calculation and, as such, fragmenting the calculation process can involve higher IM amounts once cumulated across investment managers.”
Another issue on which BNP Paribas Securities Services can guide clients is collateral optimisation. The market is concentrated around securities as collateral, but many phase five and phase six firms do not necessarily own large volumes of these financial instruments so may have securities that are not considered eligible by a counterparty.
Jérôme Blais, Head of Business Development and Client Solution, Triparty Collateral at BNP Paribas Securities Services, observes that although cash is acceptable according to the regulations, counterparties prefer not to have cash left on the books of their custodian.
“We are working with firms to combine custodial and collateral management services with collateral transformation,”
“This means that when clients require high-quality liquid assets, they can initiate an order to our trading desks to convert less liquid or less highly-rated assets into high-quality assets to be posted to their counterparties.”
“In addition, we are helping those who find it challenging to fully implement uncleared margin rules by calculating initial margin amounts using industry standards and connecting to market utilities which are key to margin and portfolio reconciliations,”
Blais explains that firms are increasingly viewing his team as a resource, where they can test ideas.
“We have been spending an increasing amount of time this year supporting clients as they determine the most effective model for their business, whether that is tri-party, using an outsourcer for collateral management or developing their own system in-house,”
“This is also why we made the strategic decision to invest in a tri-party collateral service, which has created the fifth global offer on the market,”
“This was a sensible move given that in Europe, tri-party now accounts for more than 95% of initial margin.”
Inevitably, the new margin requirements for non-cleared derivatives have not been universally welcomed.
“While the objectives are praiseworthy, we must also recognise that they don’t address demands to raise the thresholds to avoid having so many counterparties becoming subject to margin requirements,”
There is also some concern around possible future treatment of cross-currency swaps. The Basel Committee and IOSCO have said they will evaluate the risks of not subjecting the fixed physically settled FX transactions associated with the exchange of principal of cross-currency swaps to the IM requirements.
Then there is the cost factor. The buy-side often seeks a directional position to hedge risk or take a specific view on some assets or groups of assets, which could imply some significant IM numbers. As a result in many cases, posted collateral implies a net funding cost, which cannot be compensated with collateral received, as the latter is simply not reusable.
“Most of the industry has opted for the SIMM or standard initial margin model because it recognises risk offsets, which is an important factor for banks, and for the industry as a whole. It implies that if you have a market risk-neutral portfolio, the initial margin numbers are going to be lower, which will minimise funding costs,”
He also refers to firms taking the opportunity to review their roster of service providers.
“They may have realised that they have a reason to take a strategic look at their service model and implement a more streamlined approach across the entire chain of services.”
While phased implementation of the final stage of the new margin rule should reduce the incidence of rushed implementations, it is vital that buy-side firms continue to push ahead with their compliance planning. Reorienting derivatives activity is not achieved overnight – it requires months of careful planning.
What is the difference between initial margin and variation margin?
Variation margin or VM covers current exposure and is calculated using the present value of derivatives (valued under mark-to-market or mark-to-model principle), whereas initial margin covers potential losses for the expected time between the last exchange of VM and the liquidation of positions in case of the default of a counterparty and is rather a market risk-based calculation.
A tri-party collateral agent specialises in providing collateral management services and manages the collateralisation of exposures resulting from principal transactions between counterparties. Such transactions include repo, securities lending and OTC derivatives