Initial Margin Challenges Confronting Asian Markets

DTCC’s Purtini Joshi outlines three key challenges firms need to address to ensure compliance with Phase 5 and Phase 6 implementation of initial margin regulations.

Since the Global Financial Crisis of 2007, regulators have prioritised reforms to address systemic risk across Asian markets and globally. One outcome was the requirement to post two-way initial margin (IM) on non-cleared derivatives trades under the Uncleared Margin Rule guidelines published by The Basel Committee on Banking Supervision (BCBS) and the International Organization of Securities Commissions (IOSCO).

Most regulators have adopted these guidelines under their regulatory frameworks. Implemented in stages and initially launched in 2016 for the largest broker-dealer firms, only a small number of market participants have been impacted in Phases 1-3. Phase 4 took effect last month, lowering the threshold for compliance to EUR 750 billion.

Recognising the challenges that the industry faced in enacting sheer volume of new agreements and custody arrangements by 2020, the BCBC and IOSCO announced in July 2019 an agreement to extend the final implementation of margin requirements date by one year, effectively creating a new Phase 6 and introducing a threshold of EUR 50 billion for Phase 5.

The final implementation, Phase 6, will take effect on 1 September 2021, at which point covered entities with an aggregate average notional amount (AANA) of non-centrally cleared derivatives greater than EUR 8 billion will be subject to the requirements.

While Phase 4, implemented in September 2019, still mainly affects larger firms, the market should already be looking ahead to September 2020 and 2021, when Phase 5 and Phase 6 will significantly expand the number of firms that must comply. In fact, when Phase 6 is introduced, it is expected to affect over 1,000 market participants, including regional banks, end user corporations, investment managers, and insurance companies.

Anecdotal evidence suggests that many firms in Asia — especially the smaller ones — may remain unaware of the requirement and unprepared to meet their forthcoming obligations. Margin requirements on uncleared OTC derivatives transactions will have a moderate to significant impact on not only capital expenditures, but also on operational processes and regulatory obligations.

For example, many firms affected by Phases 5 and 6 have not yet taken proactive steps to establish credit support arrangements required under the rules nor identified if they are even impacted. To help ensure compliance, firms should start preparing now and address three key challenges.

 Key Challenge 1: The Exchange Process

Custodians are lynchpins in the collateral process, and under current practices, broker-dealers and buy-side firms generally use different custodial service providers. This raises the need for enhanced connectivity between custodians and broker-dealers to support margin exchange.

In a typical scenario, a broker-dealer would leverage a tri-party agent to post collateral on behalf of their counterpart, while the buy-side counterpart would use their existing custodian to segregate the required collateral in the name of the broker-dealer. This means that the broker-dealer posting collateral would instruct their tri-party agent (as is currently the case), but when receiving collateral from a buy-side client, they would need to be connected to multiple custodians to identify/receive collateral from their various counterparties.

It is not yet clear how the industry will address this challenge as the number of financial service providers posting and receiving collateral multiplies.

Key Challenge 2: Documentation

The reporting requirements around the exchange of IM are significant and should not be underestimated. As the deadlines for Phase 5 and 6 approach, companies in scope must carry out due diligence on their IM obligations and prepare the necessary documentation.

Each firm will need to publish disclosure letters giving counterparts insight to the exposures for which they must start posting IM, an essential first step toward margin exchange. In the same vein, firms should also define the overall infrastructure and framework to be put in place so that margin transactions do not fail at the last moment. This documentation process, specifically the repapering of the contracts required to exchange margins, can be time- and resource-intensive as well as costly, making it a key challenge for the market.

To address this area, BCBS/IOSCO issued a statement in March 2019 noting that the Working Group on Margin Requirements (WGMR) framework “does not specify documentation, custodial or operational requirements if the bilateral initial margin amount does not exceed the framework’s EUR 50 million initial margin threshold”. This, in effect, acts as a second threshold and relieves the smaller firms from having to initially introduce documentation. However, these firms will still need to actively monitor and manage their IM levels, as, once this threshold is breached, they will need to be in full compliance.

Market participants must take the initiative to ascertain their obligations and have their documentation in order ahead of their eligibility date — meaning as early as this year.

Key Challenge 3: Operational Efficiency

Perhaps the biggest challenge confronting market participants is understanding the operational impact of having to exchange bilateral IM, and how to most efficiently manage margin activity and collateral.

Most broker-dealers that participated in the first three phases have already progressed from manual infrastructures to a more automated, straight-through processing (STP) solution. But, at present, most buy-side firms do not post bilateral regulatory margin; they are highly reliant on dealers and some simply pay what their dealer quotes them. One reason for this dependency is the lack of systems and infrastructure needed to operationalise two-way margin calculation and posting, especially when dealing with counterparts in markets with T+1 settlement.

Many firms, especially smaller market participants, may not have the operational means to transfer eligible IM quickly enough to meet T+1 requirements, restricting these firms from accessing T+1 jurisdictions while disadvantaging broker-dealers in these markets. Added to this complexity is the restriction on the rehypothecation of collateral, which requires firms to monitor their inventory efficiently to manage the capital costs associated with High-Quality Liquid Assets required for posting IM.

To ensure market access, firms will need to focus on automating their collateral operations if they wish to scale and meet market timelines. This includes looking at their collateral management practices and making automation and optimisation choices to ensure efficient margin exchange.

The Operational Solution

Firms who have yet to address the coming collateral management challenges may opt to create customised operational solutions, which can be expensive and may not prove scalable as margin requirements grow. Others will adopt a utility solution. Such solutions enable STP “out of the box”, delivering improved efficiency for collateral transfer among market participants based on a centralised set of communication and settlement instructions. By implementing this degree of automation, smaller as well as larger firms will be better placed to meet the operational challenges associated with becoming compliant with the future phases of initial margin regulations.

With the next two phases of requirements nearly upon us, firms — particularly firms not yet impacted — need to understand not just the legal obligations incumbent on them, but also the operational requirements. These preparations must run in parallel to be fully ready for the challenges ahead — first for Phase 5 in September 2020 and then, most crucially, for Phase 6 in 2021.

Purtini Joshi is Head of Collateral Sales for Asia Pacific at DTCC (the Depository Trust & Clearing Corporation).

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