Initial Margin Regulation: Preparing for the Big One

The impending final waves of the global Initial Margin (IM) rules for un-cleared derivatives are the biggest regulatory event since the Markets in Financial Instruments Directive 2 in 2018. The rollout of the IM rules began in 2016 and is being implemented in six waves. The initial in-scope threshold was set at $3 trillion (or local market equivalent) of un-cleared derivatives and has been gradually lowered with each subsequent wave. Originally, there were only five waves but the Basel Committee on Banking Supervision (BCBS) and the International Organization of Securities Commissions (IOSCO) created a sixth wave to alleviate some pressure on the industry. BCBS and IOSCO delayed the fifth and sixth waves by a year in reaction to the market volatility caused by the COVID-19 pandemic.

To date, only the largest global banks and broker dealers have been caught by the rules, with fewer than 50 groups impacted in the first four waves. This is set to change when the threshold drops from $750 billion to $50 billion (or local market equivalent) in 2021 and drops again to $8 billion (or local market equivalent) in 2022. According to the International Swaps and Derivatives Association (ISDA), at least 1,000 entities and over 9,000 trading relationships will be captured by the final two waves of the IM rules. This will be a significant event across the financial industry because the IM rules impact the whole ecosystem, including counterparties, such as broker dealers, custodians, and market infrastructure.

The final two waves capture a number of asset managers, forcing them to implement major changes to their existing operational processes and custodial relationships. The consequences of being unprepared are dramatic; firms that are not ready by the deadline won’t be able to trade un-cleared derivatives.

A Pyrrhic Victory

Recognizing the potential impact of the final two waves, global regulators may provide some measure of relief. The BCBS and the IOSCO published guidance that firms in scope of the un-cleared derivative threshold but with less than $50 million in initial margin to post per counterparty, can defer the documentation, custodial, and operational arrangements. While welcome, the relief would be no panacea. As Fergus Pery, EMEA Head of Collateral Management at Citi Securities Services warns, “It’s not a ‘get out of jail’ free card. Firms that can take advantage of the relief still have to constantly calculate and monitor their threshold levels to make sure they are still below the $50 million sub-threshold.” In order to do so, firms still need to implement new workflows and systems to identify in-scope transactions and run regular IM calculations. Given the substantial amount of work involved to ensure that they are below the $50 million sub-threshold, the relief would seem like a Pyrrhic victory.

Coming to Grips with the Operational Challenges

Perhaps the biggest challenge is calculating initial margin. It is a difficult exercise, and for most asset managers it is entirely new. Many will need to invest in technology or look for outsource solutions to ensure they can calculate the daily margin amounts. In either case, this requires the development of new expertise to oversee the process. IM threshold monitoring is beset with other complications too. For instance, a principal such as an insurance company may split its business across different asset managers. Those same managers will have multiple bank counterparty relationships. Under this scenario, the IM sub-threshold for the insurance company would need to be monitored across all of its asset managers and the relevant dealers. However, the asset managers facing off with the insurance company will not have the information about each other’s positions. This makes it nearly impossible for the asset managers to accurately monitor the IM thresholds. “Firms need to think carefully about who is responsible for monitoring the threshold,” says Caroline Meinertz, Partner at Clifford Chance. “If it is the asset manager, they need arrangements to facilitate an information exchange in a way that does not disclose sensitive commercial information.”

Firms need to think carefully about who is responsible for monitoring the threshold. If it is the asset manager, they need arrangements to facilitate an information exchange in a way that does not disclose sensitive commercial information.

Caroline MeinertzPartner, Clifford Chance

The rules also mandate that the initial margin must be held in pledge accounts at an unaffiliated custodian for each counterparty relationship. In addition to the custodial arrangements, a bilateral Credit Support Annex, which governs the collateral arrangements between the trading counterparties, needs to be put in place for each counterparty relationship. All of this takes time, as Meinertz notes, “Based on the first three waves, we know that negotiating custodial agreements and other documentation requirements can take over nine months to complete.” Firms should take this timeline into account as they prepare for the 2021 and 2022 deadlines. This goes for firms that are currently under the $50 million sub-threshold as well.

Another consideration is that the scale of the fifth wave may put additional strain across the industry. “With so many firms potentially inscope, there’s a real risk of a bottleneck if everyone leaves it to the last minute. custodians, broker dealers, and law firms will all be dealing with multiple parties looking to get their IM ducks in a row,” warns Pery. This will put stress on resources across the industry and could lead to delays in finalizing the necessary arrangements. The sooner firms start to enact their IM plans, the better chance they have of avoiding any delays.

The Rise of Tri-party

Unlike the variation margin rules, under the IM rules both counterparties have to post collateral on the same day. The added burden of posting IM for the first time will require firms to access a broader range of collateral. A potential solution for this is the use of tri-party collateral management, where both counterparties use a third-party agent to manage collateral. Tri-party arrangements were used extensively by market participants in the first three waves of the IM rules. However, asset managers are typically less familiar with the model because traditionally most derivative margin posting is done bilaterally. The added complexity of daily, dual-sided margin posting means that firms caught in the fifth wave should consider leveraging the tri-party approach for IM. As Pery notes, “There are no rights of rehypothecation and no risk of over-collateralization as the IM assets are held in segregated accounts. As firms start to consider the cost of collateral, using a tri-party structure may make a lot of sense.”

There are no rights of rehypothecation and no risk of over-collateralization as the IM assets are held in segregated accounts. As firms start to consider the cost of collateral, using a tri-party structure may make a lot of sense.

Fergus PeryEMEA Head of Collateral Management, Securities Services, Citi

Another advantage of the tri-party model is that there is a broad swath of eligible collateral available. This is particularly relevant for non-US firms because outside the US firms aren’t required to use cash for collateral. Implementing tri-party solutions comes with its own challenges. Firms may need to establish new workflows and build connections to the tri-party provider; along with additional legal documentation, and the appointing and oversight of the tri-party provider. Nonetheless, it is likely a number of firms will seriously consider the tri-party model when faced with the challenges of implementing the IM rules.

Hope for the Best, Prepare for the Worst

The last waves of the requirements pose a number of operational challenges for asset managers, adding to their costs at a time when margins are already being squeezed heavily. This is particularly true for smaller firms, which may deter them from using derivatives to hedge their risks. The industry continues to lobby regulators to increase the $8 billion threshold to either $50 billion or $100 billion. However, given that policymakers opted grant the industry relief by extending the implementation period, it appears there is little appetite to raise the threshold.

Whether firms are in the fifth or sixth wave, they should continue to prepare for the implementation and assume there will be no further regulatory relief. This means looking now at the solutions, they can put in place to mitigate the cost of the new rules. The deadlines will be here in no time and firms cannot afford to be unprepared.