As of September 1, 2019 many fund managers must know whether they meet the threshold for posting initial margin, calculate it correctly and set up the right custodial contracts with broker-dealer counterparties and custodians. That deadline represents the fourth of five phases of initial margin requirements which were first imposed by multiple regulators in 2016 as a means for counterparties to buffer against each other’s default because there was no clearinghouse acting as the middlman. The requirement to post variation margin — or additional margin to reflect the change in the mark-to-market value of a swaps contract–was implemented in a two-pronged approach in 2016 and 2017.
Although neither US banking regulators nor the Commodity Futures Trading Commission (CFTC) directly oversee fund managers, buy-side fims will still need to comply with initial margin requirements. That is because their swap dealer counterparties must collect that margin within a day after a trade is executed.
As of September 1, 2018, the threshold for the initial margin requirement came to US$1.5 trillion in daily aggregate notional amount of uncleared swaps. The high figure meant that the largest swaps dealers would be most affected. In September 2019 fund managers will likely fall into the mix as the threshold is lowered to US$750 billion and most will be affected in September 2020 as the threshold is further slashed to US$8 billion.
About forty of the world’s largest swap dealers are already subject to the initial margin rules which began with a threshold of US$3 trillion in daily aggregate notional amount outstanding. An estimated 100 to 200 firms are expected to be impacted in 2019 and over 1,000 in 2020. Fund managers will likely fall under the 2019 to 2020 time-frames.
Although fund managers will need to calculate initial margin far less frequently than variation margin, it won’t be a piece of cake. Unlike variation margin which is usually posted by only one of the two counterparties, initial margin must be exchanged by both, explains Mathew Lewis, senior vice president and global head of the banking and regulatory practice at Axiom, a New York-based legal services and technology provider.
The two-way margin definitely reduces counterparty risk for fund managers, yet it can increase their trading costs leading some fund managers to consider their investment strategies. Finding out whether or not one must post initial margin will take a good amount of legwork. Each party to the uncleared swap transaction will have to determine with each of their affiliates and counterparties initial margin thresholds, the eligible collateral and haircuts. There could be anywhere from several dozen to several hundred counterparties and because only new trades are affected it might take a fund manager months to reach the threshold.
Fund managers won’t have to post collateral if the initial margin amount comes to less than US$50 million. Margin won’t be required for trades in currency forwards and swap contracts, although they must be included when calculating net aggregate exposues. Fund managers will need to inform their counterparties of the value of the over-the-counter derivative book of business early enough, so they can take the correct preparations for margin collection.
When calculating initial margin, fund managers can use proprietary models approved by regulators or the same model used by their counterparties, such as the popular parametric value-at-risk standard initial margin model (SIMM) developed by the swaps trade group International Swaps and Derivatives Association (ISDA). “However, even when using the same model as their counterparties, differences in data inputs, such as sensitivities, the economic details or open positions, could result in disparate IM calculations,” says Lewis. “When that happens fund managers and swap dealers will need to quickly resolve the discrepancy by changing the inputs or reconciling any data differences.”
Technology can go a long way to easing the pain of worklow and number crunching. As is always the case with new regulations, IT managers will have to decide whether to build new in-house applications, adapt existing ones or rely on third party vendors or rely on a combination of the three options. Collateral management applications will need to keep track of whether the fund management firm meets the initial margin thresholds, the types of acceptable collateral and what collateral is actually available before any initial margin calculations are made.
There are plenty of external firms only too willing to cash in on stress related to calculating initial margin using SIMM. The Stockholm-based TriOptima says that its web-based platforms can offer out-of-the-box sensitivity calculations for SIMM, automated exchange of margin calls and the reconciliation of sensitivity data for bilateral trades. Only a simple trade file is required to do the math and workflow.
As FinOps Report went to press Norwell, Mass-based margin automation software firm AcadiaSoft announced it would be offering new services with Quaternion Risk Management Bloomberg to streamline inputs necessary for margin calculations using SIMM. Last year, AcadiaSoft made available open source code for SIMM as a free download so that financial firms won’t have to code the SIMM themselves or hire an outside firm to do so. New York and London-based IHS Markit, which already offers an initial margin negotition and documentation service, says it will be rolling out a hosted initial margin calculation service based on market feeds and risk sensitivities.
Operational challenges aside, fund management firms will have plenty of repapering to do. They must either create new credit support agreements to account for the initial margin or amend the ones they have adopted from ISDA’s margin protocol. Fund management firms will ultimately need to decide on whether they wish to use one or more CSAs, says Cross. The ultimate strategy will likely be contingent on the outcome of conversations with underlying fund clients who might be facing initial margin requirements for the first time.
Since initial margin needs to be pledged in favor of the counterparty, a specific custody framework also has to be implemented,. “The new custody arrangements will be familiar to mutual funds and other funds registered under the Investment Company Act of 1940, but for all others it will be a new experience,” says Andrew Cross, a partner with the law firm of Perkins Coie in Washington DC. “The process of putting these arrangements can take time, since it is three-way negotiation.”
The new framework will be based on a dedicated account control agreement (ACA) signed between the fund manager, broker-dealer and a custodian bank which can either serve as a tri-party agent or a third-party custodian. A tri-party agent typically handles margin calculations and transfers, while a third-party custodian only holds onto collateral. The custodian must segregate initial margin from its own funds, have an enforceable default process and back-up plan in the event of bankruptcy.
Although the timetable for the fourth wave of initial margin requirements seems far away, fund management firms need to quickly start preparing, recommend collateral management experts. Arranging new agreements with counterparties and custodians could take anywhere from a few weeks to a few months to complete. No one wants a repeat of the previous embarrassing snafus experienced in 2016 and 2017 when the CFTC was forced to delay enforcement action for those not complying with initial and variation margin requirements. Fund managers and broker-dealers apparently hadn’t gotten around to signing contracts with custodians.