The collateral space is facing an onslaught of regulations currently, including UMR. What are the headline challenges facing custodians?
Phase 5 of the BCBS-IOSCO Uncleared Margin Rules (UMR), which was introduced earlier this month, presented two major challenges for custodians. The first challenge was the need to segregate the collateral which they are holding for buy-side clients. UMR requires buy-side firms to open a segregated account with their custodian bank and it can take time to negotiate an agreement.
The second challenge that custodians faced was around the movement of collateral. In order to release collateral from a segregated account, both the buy-side client and the broker need to notify the custodian of the instruction and, in many cases, firms are sending faxed instructions to release collateral. As we know, these faxed instructions are highly manual and require a call-back to the sending party to authenticate, which creates risk, increases costs and reduces overall liquidity. It is highly recommended for firms to focus on their internal operations and identify solutions to automate this process.
Both of these issues use up considerable resources at custodian banks and, with Phase 6 – which impacts buy-side firms with more than $8 billion average aggregate notional amounts, or AANA – just one year away and potentially capturing twice the amount of buy-side firms as Phase 5, these issues are likely to get much worse.
Is there an extra-territorial impact to UMR?
BCBS-IOSCO UMR requirements were rolled out globally across major jurisdictions to enhance safety across the derivatives markets. As a result, larger buy-side firms around the world and their custodians have already been impacted by this regulation in earlier phases. However, Phase 6 is expected to reach new markets that haven’t been impacted before, and where many firms are located which meet the >$8 billion AANA, such as in Korea and Taiwan. When these new buy-side firms come into scope, their local custodian arrangements will also be impacted and fall under the regulation.
How did those affected handle the shift to UMR as part of Phase 5, and did the delays give the desired and required breathing room?
There is no doubt that the delays to Phase 5 of UMR were welcomed by some market participants as it gave them additional time to prepare for the implementation of the regulation. A large number of firms made good use of this additional time by making the necessary changes to their systems and processes in order to comply, including efforts to set up new segregated margin accounts and the signing of new collateral agreements. However, for other firms, despite the extra time which was granted to prepare, the lead up to the go-live of Phase 5 was a frantic race towards the end.
Now that Phase 5 has begun, it appears that clients are being cautious and some have reduced their activity somewhat, in order to avoid reaching the initial margin threshold. However, if a fund has a certain trading strategy, eventually it will need to be implemented. Therefore, if there has been a cautious start to get a better sense of how everything works, this will likely be short-term and we expect to see activity pick-up in the coming months. That said, firms need to be aware that in some cases, legacy trades may come into scope in the initial margin calculation, and with a few large, new trades, the initial margin threshold could be reached more quickly than anticipated.
What challenges would you say await Phase 6 firms, and have you found in the other phases that firms are underestimating the difficulties associated with compliance?
There were approximately 300+ firms that fell under Phase 5 of UMR and that number could rise to around 600+ under Phase 6. Crucially, the buy-side firms in scope for Phase 6 will include smaller firms that typically have less middle and back-office resources. Therefore, in order to be ready for implementation, these firms will likely have to make more significant changes and investments to their middle-office processes than the majority of firms that were in scope for Phase 5.
With this in mind, it is important for clients to look strategically at their book to understand what the requirements are and then, to plan accordingly. Firms may want to perform their own analysis of AANA ahead of the mandated observation period, since this will give them a head start. In addition, preparations should start much earlier in the process to prevent a rush at the end, such as the one we experienced as firms prepared for the UMR Phase 5 implementation earlier this month. We’ve heard that there are a number of firms that are solely focused on monitoring initial margin thresholds, but as mentioned earlier, the initial margin requirement can move rapidly, yet the system, documentation and operational changes required to comply with Phase 6 may not.
Are there any concerns about the impact that severe market volatility could have on those who are unprepared or are lacking certain processes or understanding of the rules?
During normal trading activity, many collateral agreements remain dormant due to high thresholds. This means that collateral is not required to be moved unless there is significant exposure between two counterparties. However, at times of severe market volatility, such as that which we experienced in March 2020 as a result of the COVID-19 pandemic, much larger numbers of collateral agreements exceeded their thresholds which led to a significant increase in collateral calls, with many firms stating that they saw volumes rise by 200 – 300% during that period. If we were to experience another extreme bout of market volatility, it is likely that this would happen again.
To manage future market volatility more effectively, firms should work with third-party providers to increase automation across the collateral management process, reduce the operational complexities and risks associated with margin call processing, and streamline other functions such as collateral settlement. Not only will this bring operational efficiencies and help firms comply with the forthcoming Phase 6 regulatory mandate, but it will also enable them to utilise their available collateral more effectively and efficiently for other purposes, thereby improving their capital and liquidity management.