Although it is still unclear which of the proposals will be adopted, the industry sees the data as so compelling that regulators will recognise the need for some form of relief.
The 2007-2008 global financial crisis demonstrated significant weaknesses in the resiliency of banks and other market participants to financial and economic shocks. Among the post-crisis reforms to address systemic risk was the requirement to post IM (initial margin) on non-cleared derivatives trades, which has been implemented in stages since 2016.
Currently, ‘Phase 3’ entities that are in scope for compliance have in excess of USD 1.5 trillion in aggregate average notional amount (AANA) of uncleared derivatives at the group level. These entities – as well as those set to come into scope in September 2019 (USD 750 billion AANA threshold for Phase 4) – are all relatively large entities.
However, in September 2020, Phase 5 will present a “cliff effect” when the AANA threshold for compliance drops to just USD 8 billion, a change that will bring into scope more than 1,100 counterparties, which equates to about 9,500 trading relationship and up to 19,000 of new custodial relationships that will need to be established according to an ISDA (the International Swaps and Derivatives Association) survey.
Compliance will entail preparing margin calculation systems, which would require regulatory approval (though proposals are being discussed to ease this requirement), as well as the development of operational capacities and systems. In addition, the necessary documentation will need to be negotiated and put in place with each counterparty, ahead of the implementation date.
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Although compliance may require years worth of advance planning and implementation, the ISDA survey determined that between 26-45 percent of newly in-scope entities and 69-78 percent of counterparty relationships are unlikely to exchange any margin at all, as they will fall below the USD 50 million threshold for IM exchange.
Effectively, the expensive undertaking to comply with the margin rules, for many firms, will result in no actual reduction in systemic risk.
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In response, industry stakeholders led by ISDA proposed in September that regulators raise the AANA threshold from USD 8 billion to USD 100 billion, which would effectively reduce the number of entities that will come into scope in September 2020, particularly those that do not present a significant amount of risk to the financial system.
Though the proposal was discussed by the Basel Committee in October last year, some insiders say some regulators want to avoid being seen as ‘soft’. It is possible that regulators may decide to only raise the threshold to, for example, USD 50 billion, a compromise that would still provide some much-needed relief for the industry.
Another proposal under consideration, which is said to be much more likely to be accepted, is the introduction of a sub-threshold, whereby IM-compliant documentation would only need to be prepared if a counterparty’s regulatory IM calculation exceeds the sub-threshold. This sub-threshold would be set a certain level below the USD 50 million threshold for IM exchange, for example USD 30 million, whereby counterparties would only be required to put in place new documentation if they exceed this sub-threshold level.
ISDA had also estimated that about 19 percent of Phase 5 counterparties and 14 percent of relationships will fall into scope solely because of the inclusion of FX swaps and forwards in AANA calculations, even though physically settled FX transactions are exempted from the actual exchange of margin (because they are short dated, liquid and present low long-term risk).
This means over 200 in-scope counterparties will have to undergo expensive repapering of contracts, without having to actually exchange IM – an effect that is expected to be felt particularly strongly in Asian jurisdictions such as China, where FX hedging is common. Regulators are said to be considering a proposal that could see the removal of physically settled FX transactions from AANA calculations.
“At this stage it is still unclear which of the proposals regulators will choose to adopt,” says ISDA Regional Director for Asia Pacific, Keith Noyes. “But, the industry sees the data as so compelling that regulators will recognise the need for some form of relief.”
“In the meantime, the industry is continuing to prepare for phases 4 and 5.”