Clearing the Decks for Uncleared Swaps Margins

Asset managers might not be affected by the new margin requirements on uncleared swap transactions for at least a year. Nonetheless, they are slowly starting to prepare for the inevitable legal and operational teething pains.

US banking regulators and the Commodity Futures Trading Commission (CFTC) have decided that effective September 2016 or March 2017, depending on the size of their notional value book of business and legal entity category, financial firms will need to post variation margin for uncleared US swap transactions. The requirement to post initial margin is being phased in starting in September 2016 with January 2020 as the final cut-off date. The CFTC has also clarified when cross-border transactions will be affected.

Asset managers entering into uncleared swap transactions with banks will be covered by the rules issued by the Federal Reserve System, the Office of the Comptroller of the Currency, the Federal Deposit Insurance Corporation, the Farm Credit Administration and the Federal Housing Finance Authority. The reason: banking authorities categorize fund management firms as financial end users. Asset managers entering into uncleared swap transactions with broker-dealers will be faced with the CFTC’s similar margin policies. Fortunately, US regulators have opted to synchronize and harmonize their rules with those of the Basel Committee on Banking Supervision and the Board of the International Organization of Securities Commissions.

“For the most part, the collateral-related challenges for uncleared swaps will mirror those of cleared swaps,” explains Karl Wyborn, a director at CloudMargin, a London-based collateral management firm offering a web-based collateral workflow tool. The big difference: regulators are making it more expensive to process swap trades bilaterally than through a clearinghouse serving as the middleman. Although the economic penalty will likely prompt more swap trades to be processed through clearinghouses, for the time being there are certainly enough uncleared contracts to give asset management firms plenty of grief.

Enter a legion of traders, risk managers, operations managers, compliance managers and legal counsel to sort out just what needs to be done on multiple fronts. “Trading and risk managers will focus on replicating collateral calculations, trade cost analysis and collateral optimization based on portfolio impact while operations specialists will be responsible for the mechanics of meeting collateral calls and settling collateral movements,” explains Joshua Satten, director of business consulting for financial services consultancy Sapient Global Markets in San Francisco. “The compliance managers will be keeping everyone in-house on the straight and narrow while attorneys will be renegotiating contracts with counterparty banks and broker-dealers.”

Fund management firms will have to discuss the ramifications of the new margin rules with each fund client. The reason: they may have to change either the type of collateral used or the amount of collateral. In some cases fund managers will also need to create new contracts or alter old ones with custodian banks governing the segregation and transfer of collateral, explains Daniel Budofsky, a partner with the law firm of Morgan, Lewis & Bockius in New York.

However, those talks will be far easier for asset managers to handle than those with broker-dealers. Fund boards are typically more concerned with how the investment strategy of the fund manager will be affected and not specific collateral requirements. That’s not the case with contracts between fund managers and broker-dealers which go in nitty gritty details on the who, what, when, where and hows.

Contract Review

Fund managers will have to review each of their contracts with broker-dealers and banks to determine the asset class of collateral that will be accepted, the haircuts applied, when collateral must be delivered, how quickly a margin call must be met and which currency to use. “Fund managers need to clean up their legal houses before making any operational and technological changes,” says Sonia Goklani, chief executive of Cleartrack, a consultancy in South Brunswick, NJ specializing in execution and clearing for derivatives. “In some cases, that means looking through paper cabinets or multiple applications to review the terms of their contracts with broker-dealers. Fund managers might even decide they can afford to unwind their contracts.”

However, before they agree to sign on the dotted line with broker-dealers, fund managers need to take their own operational capabilities into consideration.  “Asset managers must know what collateral they can operationally deliver now and under the impending margin rules,” says Mathew Keshav Lewis, co-head of the global banking practice for Axiom, a New York-based legal services and technology provider. “They will have to make informed choices, because the wrong decision will be financially and reputationally costly.” An investment strategy could easily go astray or contractual promise could be broken.

Naturally, the highest-volume fund management firms will likely carry the most clout to get what they want. “Fund managers which have multiple business relationships with broker-dealers — such as trade execution and clearing for both cleared swaps, uncleared swaps and listed derivatives– can negotiate the margin contracts to their advantage,” notes Goklani. Smaller to mid-tier players will have a harder time at the bargaining table considering the dwindling number of clearing providers.

The trade group International Swaps and Derivatives Association (ISDA) has created a standardized protocol or legal language that can be used by asset managers, banks and broker-dealers seeking to either change their current credit annex agreements or create new ones for variation margin. Some fund managers tell FinOps Report that the protocol is too restrictive and favors broker-dealers and banks, so they would rather ask their compliance and legal departments to battle it out. Other fund managers are more optimistic, saying the protocol will cut down on negotiating time.

“The decision on whether to use the protocol will depend on multiple factors including how bespoke are the existing agreements are and whether changes to existing contracts must be made or new ones drafted to meet updated business needs,” says Lewis. For asset managers who need more legal muscle or must add derivatives experts in a pinch to meet regulatory deadlines, Axiom can help their customers with attorneys and content specialists to handle contract negotiations and figure out the necessary processes and technology.

Once the task of making contractual changes is out of the way, fund managers will need to address operational changes. Those who have been relying on spreadsheets to calculate their new margin requirements and meet margin calls will have to up their game. The math is far too complicated, and with the number of margin calls expected to grow exponentially, asset managers risk expensive errors if they don’t find automated answers.

Fund managers can’t afford to miss a margin call, use the wrong collateral, or send the collateral to the wrong counterparty.  An unautomated fund management firm could spend US$3.6 million by 2020 to clean up failures to settle collateral requirements for bilateral swap contracts, warns a recently published report by US clearing and settlement infrastructure Depository Trust & Clearing Corp. (DTCC), international securities depository Euroclear and global consultancy PricewaterhouseCoopers. That figure represents a 407 percent increase from 2016.

Of the two types of margin detailed in the new US and foreign rules, initial margin is considered the most difficult to calculate and operationally administer because it is intended to buffer against a potential counterparty default. By contrast, variation margin reflects the value of the swaps contract in any given day. Because margin will likely become a scarce resource, asset managers will need to figure out how to use what they have wisely.

Relying on cash is expensive and US Treasuries are not always feasible because they might not have enough to go around for multiple transactions. Asset managers who prefer to use other types of securities will need to take extra precautions that they aren’t wasting their collateral — or using more than absolutely necessary. Using complex algorithms, some collateral management systems can optimize or select the cheapest collateral to use. In a crunch, firms may have to resort to collateral transformation — exchanging lower-quality for higher quality collateral.

In a best-case scenario, the collateral management system will be integrated with an electronic document application and a centralized collateral inventory system. Collateral management systems that can be used for multiple asset classes — not only swaps — are optimal because they can squeeze out the maximum collateral value by taking into account more than just derivative contracts.

Collateral as Profit Center

For fund managers wanting to go the extra step, collateral management can become about far more than just assigning collateral after the fact — or after the asset manager has already entered into the trade. It can offer advance knowledge of collateral costs. “Pre-trade analytics will become critical to verify which trades should and shouldn’t be done based on the amount of necessary collateral,” says Satten. “In some cases, using another bespoke contract or a cleared swap contract or even a futures contract could be just as effective as an investment strategy but require a different amount or type of collateral.”

The savviest asset managers will go even further and turn collateral management into a potential money-maker. “They could figure out how to switch collateral that would ordinarily be used for the swap trade of one underlying fund client for another client or in a repurchase agreement,” says Goklani. “Machine learning and technologies such as blockchain could help with the what-if analysis and automating the collateral management process.”

For fund managers who don’t have the stomach to handle collateral management on their own, outsourcing is a possibility and there are multiple options, based on the investment strategy, the size of the book of business, the number of deals involved and specific tasks. BNP Paribas Securities Services, for one, is among a handful of custodians offering the gamut of middle and back-office services ranging from trade confirmation all the way to collateral optimization, transformation and reporting to trade repositories through its Collateral Access unit. Asset managers can pick and choose one or more to focus on trade execution.

“Asset managers are looking at the complexities of collateral management and potential operational risk when deciding to outsource,” says David Beatrix, a business development manager for BNP Paribas Securities Services in Paris. He would not specify the number of asset managers using the bank’s outsourced service or which functions, but US asset managers tell FinOps Report that trade confirmation and regulatory reporting are the most common tasks assigned to custodians.

Another alternative for asset managers is the managed services approach. “Outsourcing much of the collateral management process is often preferred by asset managers operating in a single geographic location or asset class,” says Satten. “However, higher volume asset managers will likely go for the managed service approach to offer the best combination of cost effectiveness and risk mitigation.”  Fund managers can pay a fixed-cost for support without being responsible for system upgrades. They can also benefit from relying on their own operations staff with only the technology platform hosted by a third-party.

Last but not least, there is always the utility model to fall back on. DTCC has teamed up with automated margin call technology provider AcadiaSoft to allow fund managers, banks and broker-dealers to electronically match up margin and margin call amounts and handle the pledging and acceptance of collateral to cover agreed call amounts. Although the new DTCC-Euroclear Global Collateral Ltd service will initially be focused on automating the communications and reporting process related to collateral movements, down the road a financing option will be introduced to extend Euroclear’s Collateral Highway triparty services to the US. A so-called “single collateral pool” could allocate assets electronically to either DTCC or Euroclear participants.

AcadiaSoft declined to comment on the initiative and DTCC officials were unavailable at press time to respond to requests for a detailed update on the status of the communications offering. A spokesperson for DTCC-Euroclear GlobalCollateral Ltd. insists it will be offered in time to meet regulatory deadlines.

However, the GlobalCollateral service isn’t for everyone. Asset managers already using AcadiaSoft and a custodian bank for their collateral management requirements might decide the combination offer enough functionality to meet their needs. A custodian could internalize the movements of collateral on its books as long as the broker-dealer counterparty used the same custodian.

The world’s largest custodian BNY Mellon, well-known as an agent for US triparty repurchase agreements, is not listed by AcadiaSoft as among a string of new investors, including other brand-name custodians, that will presumably use the GlobalCollateral offering. BNY Mellon has never discussed its notable absence, which asset managers view as a sign of a competitive threat. Because BNY Mellon is already used by the largest broker-dealers as their triparty agent for US Treasuries, the bank could deliver benefits similar to the GlobalCollateral utility. The bank could also offer collateral optimization and transformation capabilities.

Other custodians, such as BNP Paribas Securities Services, have no qualms participating. “We don’t view the GlobalCollateral utility as competition, but a complementary service for asset managers,” says Beatrix. He notes that asset managers would still need to build connectivity to the service as well as handle margin calls disputes and collateral optimization and transformation by themselves or through custodians.