Investment funds, which have to meet initial margin requirements for uncleared derivative transactions in 2020 and 2021, will soon find that their biggest legal and middle-office challenges could be dealing with custodian banks.
Far more investment funds will be affected by the final phases of initial margin requirements than in the initial four phases, starting in 2016. Although funds likely have relationships with multiple custodian banks they might never have exchanged initial margin with counterparties for uncleared derivative transactions. What’s more, not all fund managers, which will likely do the nitty-gritty mechanical work on behalf of fund clients, have developed the necessary third-party operational and control processes necessary to manage collateral.
Until recently, September 2020 was supposed to mark the last phase of initial margin requirements for funds and other entities which exceed the threshold average notional amount (AANA) of non-centrally cleared derivatives of US$8 billion. Concerned over the steep increase in the number of institutions in scope for the September 2020 deadline, regulators in July 2019 opted for two separate final phases. Funds and other entities with an ANNA of more than US$50 billion will need to comply with initial margin requirements as of September 2020 and those with an AANA of more than US$8 billion will need to do so as of September 2021. Industry estimates are that several thousand funds could soon be hit with the new requirements compared to only a handful during the first four phases.
Addressing account control agreements are one of a multitude of tasks necessary to prepare for initial margin rerequirements. Funds, through their managers, must also disclose to counterparties whether they expect to fall under the fifth and sixth phases of initial margin requirements and exchange information on how initial margin will be calculated along with the agreed type of asset class to be used and haircuts that will be applied.
The new account control agreements will dictate the tasks custodian banks will perform and when. Operations managers at funds, or their management shops, must then figure out how to transfer the right value of collateral in the right assets to the right custodian. The account control agreements are necessary for initial margin because custodian banks are required to segregate the collateral from their own assets. Variation margin (VM) is also used in uncleared derivative transactions, but it doesn’t have to be segregated by custodians and can be held by each of the counterparties. Unlike VM, which is meant to address fluctuations in the daily value of an uncleared derivative trade, initial margin is intended to protect against a counterparty’s default or bankruptcy.
Picking a custodian sounds simple enough if the fund has an existing relationship with a bank. However, what if the counterparty has its own preference? If the fund doesn’t agree with the broker dealer’s choice and decides to select another custodian, its efforts to comply with initial margin requirements will become a lot more stressful. The fund will need to establish a contractual agreement with two custodians — one to act as its regular custodian and hold assets that it will pledge as collateral and the other to accept collateral that the fund pledges.
“Fund managers will typically pick a custodian from a list of the broker’s preferences and given there are a handful of custodians doing the job, chances are there won’t any dispute over the selection process,” says Andrew Cross, a partner with the law firm of Perkins Coie in Washington DC specializing in investment management regulations.
Several global fund management firms contacted by FinOps Report (www.finopsinfo.com) cite BNY Mellon, State Street, Citi, and JP Morgan as the most popular providers for initial margin services for uncleared swaps.
The decision on which custodian to select also depends on the level of services the fund or its manager want and how much the fund is willing to pay. Two options are available: the simple third-party and the more complex tri-party agreement. “The third-party agreement means that the custodian bank is only responsible for segregating the collateral and transferring it to a broker-dealer counterparty,” says Cross. “The triparty agreement requires the custodian be involved in decisions about which asset to use as collateral from a pool of assets and how to value the collateral.” So far, compliance managers at several US management firms tell FinOps Report that most funds have opted for tri-party deals for one of two reasons; they were either pressured by their broker-dealer counterparties to do so or because they couldn’t do all of the operational work on their own.
Regardless of whether a third-party or tri-party agreement is signed, the terms must inlude just what happens when the pledgor is in default under the trading agreement or when the custodian decides it no longer wants to offer is services. Should the pledgor be in default, the secured party which was supposed to receive the collateral can notify the custodian it is exercising exclusive control over the collateral. If the custodian no longer want to fulfill its obligations the fund would need to find another custodian, typically within thirty to ninety days of being notified.
Yet another provision that must be included in any account control agreement is the process whereby the pledgor can recall or ask for the return of excess collateral. Among the reasons for excess collateral are the execution of new trades, the termination of outstanding trades or changes in the notional amount of a trade. The recall may require a multi-step worklow of a request by the pledgor and consent from the secured party.
In the case of a triparty account control agreement, the fund and its custodian will also need to agree on a few extra details related to the collateral such as the type of assets that will be used and the responsibility of the custodian to value the collateral. US regulations require the custodian to promptly reinvest cash collateral in money market funds.
Don Macbean, a partner with the law firm of Katten Muchin Rosenman in New York, cautions that the terms of account control agreements should not conflict with the terms of credit support annexes which are signed between the trading counterparties. What happens if there is a discrepancy? “The custodian will say that it is bound by the terms of the account control agreement regardless of what the credit support annex says,” says Macbeam. Differences would occur with the type of eligible collateral, the timing of collateral transfer, the interest rate payable on posted collateral or substitution rights.
Using international securities depositories Euroclear Bank and Clearstream as custodians presents extra legal wrinkles and expenses making US fund managers hesitant to tap them. For starters, the laws of multiple countries may apply. Case in point, says Euroclear: an agreement between counterparties, such as the collateral transfer agreement might be governed by New York or English law, and the pledge agreement might be governed by Belgian law. The agreement between counterparties and Euroclear Bank might be governed by English law. Fund management firms that don’t wish to be direct members of Euroclear Bank or Clearstream would also need to use an intermediary custodian bank member of Euroclear and Clearstream to use the services of either international depository.
European fund management firms appear far more likely than their US peers to rely on Euroclear or Clearstream to serve as custodians for initial margin requirements. “During the first phases of initial margin requirements only a handful of European buy-side institutions signed up for direct membership to use Euroclear’s triparty collateral management service,” says Olivier de Schaetzen, head of product solutions for collateral management at Euroclear in Brussels. Those buy-side firms, he explains, were subject to the new initial margin rules because they were considered affiliates of large global banks which met the required thresholds of trading activity. De Schaetzen expects the number of firms using intermediary custodians to connect to Euroclear to increase during the fifth and sixth phases of the initial margin requirements as many buy-side firms may not have the size or willingness to manage a direct relationship with the international depository.
The International Swaps and Derivatives Association (ISDA), the Washington, DC-based trade group representing the over-the-counter derivatives market, has included third-party account control agreements with custodian banks on its Create platform so fund managers and custodians can automate contract writing through pre-defined templates. So far, only BNY Mellon has signed up as custodian bank to use the platform for account control agreements. Swaps data giant IHS Markit, which offered a rival Margin Xchange platform in conjunction with the law firm Allen & Overy and SmartDX, has decided to shut down its service.
Even the best written contract won’t be enough to protet the fund and its manager if the fund manager lacks the necessary automation. “Too many entities are still relying on faxes to ensure proper authorization to release collateral back to the pledgor,” acknowledges Amy Caruso, director of collateral initiatives for ISDA in New York.
Operations managers at several custodian banks tell FinOps Report that they are encouraging fund managers to use the ISO 15022-compliant message types through SWIFT’s network. The La Hulpe, Belgium-headquartered global message network provider has created five ISO 15022 compliant message types related to initial margin requirements. The MT 202 and MT 210 messages involve transferring cash as initial margin and the MT 540 and MT 542 messages relate to sending money market funds as collateral. Another ISO 15022-compliant message, MT 527 ,can be used if the custodian bank acts as a triparty service provider. SWIFT officials say that the MT 202 and MT 210 message types will be available in equivalent ISO 20022-compliant formats in November 2021. SWIFT is developing an equivalent MT 527 message in the ISO0 20022 compliant format.
It could not be determined just how many fund managers and custodians are using the SWIFT message types for initial margin requirements but it is likely that as existing SWIFT members, the largest fund management shops could be far ahead of their smaller peers. “It is important for entities to start the process of adjusting to SWIFT message formats and workflows required as soon as they engage with custodian banks and during the onboarding process while ironing out the terms of their contracts,” says Caruso. “They can’t afford to wait until they have signed contracts to test the operational process.”
Yet another communications option: the Margin Transit Utility (MTU), a service offered by GlobalCollateral, jointly owned by the US Depository Trust & Clearing Corp. (DTCC) and Euroclear. DTCC says that over thirty fund management firms and nine custodians have signed up to use the service which allows margin instructions to be converted into settlement instruction and release notices using the SWIFT ISO-compliant message types. DTCC does not disclose which firm is using the MTU for which specific collateral purpose, but lists Brandywine Global Investment Management, Fidelity International, Franklin Templeton, Vanguard and Brown Brothers Harriman as among the users.
Legal experts recommend that investment firms carefully understand their operational capabilities before signing off on their account control agreements. Finding out their obligations after the fact isn’t a good idea. “It is critical for operations managers at fund management firms to be informed of the proposed operational terms of their account control agreements as they are being drafted to know whether they can deliver on their commitments,” says Macbean.
Details, such as the timing of the collateral movement, need to be ironed out in advance particularly when different time zones and countries are involved. zeotkinh hours and holidays may vary. Funds also need to be certain they can actually pledge the asset class of collateral promised. It might not be available or its use could be restricted.
Given all the intricate details involved in fulfilling an account control agreement, attorneys have a final word of advice before putting one’s John Hancock on the dotted line: leave it to the experts. “It’s best to task internal derivatives counsel with the responsibility to sign off on the agreement as he or she has the required expertise to understand the nuances of derivative contracts,” says Macbean. “Relying strictly on generalist internal counsel is dangerous as derivative contracts are complex and failing to understand what appear to be innocuous terms can have significant consequences.”