By Scott Sobolewski, Head of US Quant Services, Acadia
While September 1 may seem like it’s far in the future, it marks the fast-approaching deadline for firms impacted by Phase 6 of Uncleared Margin Rules (UMR). The goal of UMR is to increase the margin requirements for over-the-counter derivatives to protect against counterparty default risk, and therfore limit potential system-wide knock-on impacts observed during the 2008 Financial Crisis. The rules have been rolled out gradually, with the largest firms having come into scope in 2016. Phase 6, coming this September, is the final phase and impacts smaller and more diverse financial institutions, including hedge funds, pension funds and boutique investment firms.
The deadline may be months away, but it is imperative for firms that trade non-cleared derivatives to take steps now to prepare for these requirements or risk being unable to operate this aspect of their business when the regulations kick in.
The requirement to comply with UMR boils down to derivatives trading volume on a firms’ balance sheet as determined by notional value; the lowest threshold for Phase 6 is $8 billion in Average Aggregate Notional Amount (AANA). To determine if a firm is in scope, it must calculate its AANA in the Spring of 2022 comprising a three-month rolling average of the outstanding amount of non-cleared derivative activity. This calculation needs to be done on an annual basis, meaning that firms not in scope for 2022 may be subject to UMR in future years as their trading volumes grow.
The importance of threshold monitoring
While the AANA calculation is what brings a firm into scope, in practice the magic number for firms is $50 million. That’s the threshold – on a per counterparty basis – that triggers the requirement for actually exchanging initial margin under the new requirements. It’s possible for firms in-scope to stay below this threshold, which allows them to avoid both the operational costs of setting up new collateral documentation and tri-party custodial relationships, as well as the funding cost of raising the additional margin required by the regulation.
UMR requires both parties in a transaction to post the margin to a segregated third-party account on a daily basis once the threshold is breached. As we observed in Phase 5, it is highly likely that many Phase 6 firms will not exceed the $50 million threshold – but it is essential that they have a monitoring process in place with built-in alerts that enable them to become operationally ready for UMR with ample lead time should they breach the threshold.
Managing risk under UMR
A common issue that arises among firms preparing for Phase 6 is the limitations of their internal risk management capabilities, particularly around calculating market risk sensitivities across their in-scope portfolios. Adhering to calculation methodologies and formats specified by industry associations such as ISDA – which often requires modification or overhauls to bespoke internal processes – has led many firms to elect to outsource the task to specialized third-party vendors.
The ability for buy-side firms to exchange standardized data on a common technology platform fosters an industrywide collaborative community with fewer disputes, greater transparency into margin calculations, and operational efficiencies. The benefit is reduced costs and institutional resource drain while still adhering to the regulatory framework of UMR. Constant improvements in trade coverage and other community-led development efforts fold easily into a firm’s overall risk management strategy and is guaranteed to be future-proofed for years to come.
From compliance to optimization
The September 1 deadline for firms to implement the appropriate governance and control processes to demonstrate regulatory compliance is absolutely critical. Firms that delay their preparations risk missing the deadline and falling behind other firms who have operationalized the anticipated costs of initial margin into their trading strategies.
The compliance date later this year is by no means the end of the process, as UMR represents a fundamental change to a firm’s cost structure. It will take time to fine tune a firm-specific approach and understand how these regulations fit their overall risk management strategy. The greater implications – and the opportunity for competitive advantage – will come from a firm’s utilization of pre-trade analytics to determine the impact of new trades on initial margin requirements, combined with portfolio rebalancing to optimize around funding, capital, and other associated trading costs. The firms who get out in front of the compliance aspects will be able to transition more quickly to thinking strategically and take advantage of the additional optimization opportunities across their portfolio while the rest of the industry catches up to them.