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Initial Margin – A regulatory bottleneck

19 December 2019

With the recent announcement of an extended preparation period for those smaller entities needing to post initial margin (IM) under the uncleared margin rules (UMR), the new timetable could cause a bottleneck for firms busy repapering derivatives contracts linked to the discredited Libor benchmark at the tail end of 2021. As the threshold for compliance reduces and more buy-side firms are caught, our UMR experts, Hiroshi Tanase, Executive Director, Product Management, examines the key preparatory steps required in a Q&A format, on margin calculation and the backtesting of IM models to smooth the process and ensure compliance.

How will the extension of the implementation phase affect firms' preparations?
The extension benefits the firms whose AANA is between $8 billion and $50 billion, or the equivalent in other currencies. These are the new phase‑six firms to come into scope in September 2021. The International Swaps and Derivatives Association (Isda) estimates 775 counterparties and 5,443 relationships in this phase. These counterparties now have the opportunity to observe and learn from the experience of phase‑six firms to implement an optimal solution. Having said that, they are advised to make the most of the extended implementation period without halting the UMR project within their organisations. For the new phase‑five firms, there is no time to waste to achieve compliance in time for the September 2020 deadline.

What impact will the rules have on firms' trading strategies?
Understandably, the current focus for most firms coming into scope in phases five and six is to have a solution in place to avoid forced and unwelcome disruption to the execution of their trading strategies. Recently, more attention has been paid to the issue of incorporating the impact of IM cost in the trading decision-making process. That is the task of pre-trade analysis, which is often coupled with complementary effort of post-trade optimisation. While it may take some time and the evolution may not follow a straight line across different types of institutions in the industry, it is conceivable in the long term that the impact of IM will be considered in some fashion even by relatively small firms. Importantly, UMR have further spurred the interest in increasing the use of cleared and exchange-trade derivatives.

How will the need to post IM affect firms' choice of products?
Once a fully fledged IM solution is in place, the in-scope firm can, in theory, continue to trade any type of uncleared derivatives. But the cost of IM may influence the preference for different products. The standard Simm offers a general solution across the entire spectrum of instrument types - together with schedule IM for certain esoteric types - and therefore no products would be off limits. The relative attractiveness of cleared derivatives and ETDs may increase for firms for which the IM funding cost is a material factor.

What tactics are firms using to reduce IM exposure?
Large sell-side firms in early phases have largely completed IM reduction and optimisation exercises. Techniques include risk transfer across IM netting sets - such as counterparties - and between bilateral, cleared and exchange-traded (where applicable) positions. IM is reduced if more risk offsets are achieved within a netting set. IM can be reduced - within limits - for both pre- and post-trade. For large broker-dealers, the emphasis is on post-trade optimisation/reduction. As with derviatives valuation adjustment - known as XVA -a decade ago, optimising IM requires not only the establishment of tools and processes but also developing understanding within an organisation, which is often a challenging and slowly evolving process - even at tier one banks with highly skilled staff. For phase‑five and phase‑six firms, reducing overall exposure by clearing more trades is currently the main tactic. The next step will be to maintain an optimally low level of IM through active use of IM optimisation tools pre- or post-trade. Pre‑trade, firms will look to identify counterparties with the lowest incremental IM. Post-trade, firms will look to put additional risk-reducing trades or novate trades, for example, to optimise IM. IHS Markit anticipates that to be a gradually evolving process.

What pressures are UMR placing on firms' resources and technology?
It is true that firms need to invest capital to achieve UMR compliance. However, the competitive market pressure has resulted in the availability of cost-effective solutions that address key elements such as IM calculation. Phase‑five and phase‑six firms should take a long-term view and obtain a solution that will prove future-proof. Different solutions have different overall impacts on in-scope firms' resources an the cost to run the daily process. Key considerations include not only the salient service features, but other important features that may be overlooked at first. For example, the reliability and accuracy of calculation is not an academic concept, but something that would directly affect the operational costs as IM disputes would directly translate into operational burden. Adequate and timely customer support is another important consideration as many phase‑five and phase‑six firms will be relying on the service provider to augment their internal staff to manage the complexity of the IM calculation process. Last but not least, the service provider's awareness of and readiness to provide adequate support for implementing model risk management, or model governance, is another key point to consider when assessing the overall viability of the solution and impact on the firm's resources.

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