“Last call” for compliance
Along with the imposition of mandatory clearing, margining requirements for non-cleared OTCs are becoming much more prescriptive in Europe under Emir, similar to the rules set out by its US equivalent, the Dodd Frank Act. At present, financial institutions holding non-cleared OTCs with an aggregate notional value in excess of €1.5trn needed to post initial margin. Given the high sums involved, this threshold currently only impacts a handful of very large market incumbents. But the rule is gradually phasing-in, with a reduced threshold of €750bn coming into play in September 2019, and dropping considerably to €8bn in September 2020. This will bring a much wider range of institutions in scope, including a number of hedge funds.
Taking collateral management to the next level
In order for hedge funds to post margin on time to the relevant OTC counterparties, they need to ensure they have robust collateral management processes in place. However, hedge funds also need to be conscious that collateral management is not an entirely straightforward exercise. For non-cleared derivatives, the regulation now define some strict boundaries in terms of what can be posted and received as collateral, mainly cash and liquid/non-risky securities. Unlike variation margins which at all times are either held or posted, depending on the value of the OTC derivatives portfolio, initial margins related to non-cleared OTC are always held and posted at the same time, since they are bilaterally exchanged and custody-segregated. It implies that each party to a relationship is both pledger and secured party at the same time, and that each party has a net collateral funding cost at all times. For funds holding insufficient assets eligible for posting, potential access to eligible collateral from banks through collateral upgrade trades has been made more expensive due to banks’ increased need to comply with Basel III’s liquidity ratios (LCR and NSFR especially).
These challenges make it difficult for firms to acquire the right collateral quickly, which can be problematic when meeting intra-day margin calls from counterparties. Given the potential for derivatives volatility over the next few years arising from deepening trade tariffs, a slowdown in global equity prices, eurozone debt risk and Brexit, firms need to have mechanisms in place by which to obtain collateral as rapidly as possible to post as margin for their cleared and uncleared OTC positions.
Service providers are here to help
A number of effective solutions are, however, available to impacted OTC users. Some fund managers are looking to their bank service providers to support them by offering collateral upgrades or transformations, whereby illiquid or ineligible assets are converted into eligible securities that can be posted as margin. While some hedge funds have investigated whether cash-rich long-only managers or asset owners would lend out their high-quality securities as eligible collateral in exchange for a fee, peer-to-peer activity has been fairly muted.
In contrast, well-capitalised and carefully risk managed custodian banks can provide clients with a number of tangible solutions, including access to automated systems connected to market utilities, credit facilities and a triparty platform that enables hedge funds to tap into liquidity providers, helping them to optimise collateral management. Most importantly, global custodians with collateral systems of the latest generation and proprietary local custody networks ensure collateral is settled and held securely in a segregated account structure in line with Ucits and AIFMD (Alternative Investment Fund Managers Directive) rules. In fact, compared to a standard non-bank administrator, BNP Paribas Securities Services offers a one-stop-shop offer to its hedge fund clients.
Avoiding collateral damage
The introduction of initial margins for non-cleared OTC transactions creates other operational issues for hedge funds. Firstly, for each trading relationship, an additional initial margin Credit Support Annex (CSAs) and two trilateral Account Control Agreements (as pledger and secured party) need to be negotiated to accommodate the new collateral requirements. This should be initiated – via self-disclosures – well ahead of the compliance date to ensure a smooth implementation and avoid the “last minute” rush to providers and custodians.
Another issue facing hedge funds is that initial margin is calculated using a different methodology to variation margin, as the former is risk-based. Broadly, regulators have said firms can either use a table-based approach or an internal model when calculating initial margin. For firms opting for the latter, and to avoid endless methodology disputes, the ISDA has rolled out a Standard Initial Margin Model (SIMM) – a sensitivity-based measure – that defines the parameters (shocks, correlations) that each firm needs to implement to calculate the initial margins as per regulatory requirements. While intuitively an internal model is designed to be more efficient than the simplistic table-based approach, and take into account the offsetting risks in a portfolio, there can be cases where some portfolios – especially if directional – will produce lower figures than the SIMM anyway.
Furthermore, hedge funds must ensure they have processes in place whereby those initial margins – posted and received – can be agreed, and segregated. The challenge underpinning the agreement of the margins does not depend so much on the model and its parameters, but rather on the sensitivity inputs to the model, which are directly dependent on the pricing process of the OTC derivatives. Investigations of disputes on initial margins require seamless connection between collateral and pricing teams, like for variation margin disputes, and gives a critical importance to the portfolio reconciliation process, an area where industry platforms have expanded their services.
Finally, when it comes to segregation, firms caught in the first waves went naturally with their triparty collateral agents to manage the trilateral ACA, as the sourcing and margin pledging/release, and eligibility monitoring processes can be handled seamlessly. But whatever the operational framework, there is some significant legal and operational implementation that needs to be anticipated.
Still some regulatory uncertainties?
The significant number of firms in line to be caught up in the 2020 wave – and the challenge of being ready by that date – prompted associations to write to the regulators in September 2018, suggesting that some of the rule’s provisions be revisited, such as the September 2020 threshold level and its calculation basis, the model governance, and the documentation prerequisites determining when the threshold would apply. It is not sure yet whether the rules as they currently stand will be amended or not. Time will tell.
Next steps for hedge funds
By 2020, hedge funds will need to have the correct infrastructure in place to facilitate margining requirements for non-cleared OTC trades, at a time when their industry is facing enormous regulatory and performance pressures. Building new systems and redrafting critical documentation such as CSAs will be a time-consuming exercise. By engaging a custodian with excellent links across the buy-side, sell-side and industry platforms, and which has an extensive range of triparty and collateral management solutions, the process can be significantly expedited.
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This article was published in HFM’s Special Ireland Report 2019.