As FinOps Report went to press, the US Commodity Futures Trading Commission (CFTC) said in a no-action letter that it would not take any enforcement action against broker-dealers that didn’t comply with its variation margin rules until September 2017. Financial end-users, such as fund managers, weren’t adequately prepared for the March 1 deadline, according to the CFTC. Still, the relief was contingent upon dealers making a best-effort to implement the requirements with each of their its counterparties by March 1.
Fund managers shouldn’t be too quick to breathe a sigh of relief. US banking regulators haven’t followed the CFTC’s lead. Nor have foreign regulators. Therefore, if a fund manager does business with a dealer that is subject to the CFTC’s variation margin rules for uncleared swaps as well as the rules of another country which hasn’t altered its effective date for variation margin rules, the March 1 deadline still applies. Uncleared swaps refer to contracts which are not processed through a central clearinghouse.
Apparently, some fund managers and broker-dealers may not have learned critical lessons from September 1, 2016 deadline for the largest swaps players in the US, Canada and Japan to meet initial margin requirements. Some didn’t have contracts signed up with custodian banks for the transfer of collateral, while others weren’t sufficiently automated. The CFTC was ultimately forced to extend until October 3 the deadline when separate agreements had to be signed with custodian banks as middlemen. The contracts were required to establish third-party custodial accounts to meet the specific rules for segregating initial margin. In other cases, fund managers couldn’t even meet a one-day deadline for collateral delivery to broker-dealers.
The first hard takeaway from those scenarios: it takes a lot of time to draft and negotiate credit support agreements (CSAs) to meet the new regulatory requirements. Depending on the size of the firm, fund managers may have to review dozens of contracts with broker-dealer and bank counterparties across the globe. They then have inform their underlying fund clients of the new terms. “Fund managers have to be proactive and come to terms with their broker-dealer or bank counterparties,” says Brendan Nelson, vice president of Axiom, a New York-based legal services and technology provider in New York. “Broker-dealers and banks will likely offer fund managers reasonable conditions for variation margin and if they can quickly agree they can get ready in time for March 1. If they want to dispute the terms at this late stage, they could find themselves left out in the cold.”
The second lesson: it’s not likely to be simple or quick to adapt middle- or back-office automation for collateral management that might be partly manual or reliant on multiple applications. Portfolio reconciliation, valuations, margin calls, and margin delivery all have to be met in a far shorter timeframe than ever before.
Initial margin is intended to buffer against a potential counterparty default while variation margin may move on a daily basis reflecting the changing value of a swaps contract. Although most fund managers already post variation margin for their uncleared swap trades, they will now have to do so following the specific rules imposed by either US or foreign regulators.
Calculating variation margin might sound easier than initial margin. However, fund managers should expect an exponential growth in the number of daily margin calls — that is, requests from counterparties for additional collateral. What’s more, fund managers can’t program their middle and back offices to comply with only one set of regulations. They need to be prepared to accommodate any jurisdiction’s rules that might impact their broker-dealer or bank counterparties.
Regulations on initial margin requirements are being phased in over the next three years. Depending on the size of the fund manager’s book of business and its designation, it could avoid the requirement. Not so with variation margin. Most fund managers will have no choice but to comply with the March 1 deadline. The only notable exception: if the amount of initial and variation margin that must be transferred or posted to the broker-dealer or bank is under US$500,000 or under €500,000 the fund manager will not be required to post the margin.
In the case of fund managers which must follow US rules, the CFTC and banking regulators are setting similar standards. The fund manager may not be directly regulated by those agencies, but will nonetheless be forced to meet the guidelines because their broker-dealers or bank counterparties must do so. Fund managers may also have to follow European regulations either directly, if they are high-volume swaps traders, or indirectly through their broker-dealer or bank counterparty.
Because the rules governing variation margin are not uniform across the globe, knowing which apply is critical. That’s no easy task. “Assuming the fund is not directly required to collect and post margin, the governing regime will most likely be dictated by which country or countries’ rules the counterparty must follow,” explains Ilene Froom, a partner with the law firm of Reed Smith in New York. “The relevant rules will also dictate other requirements, such as what may constitute eligible collateral, haircuts that must be applied and when collateral must be transferred or provided.”
What is keeping fund managers from readiness for the March 1 start date? The volume of documentation that has to be exchanged with broker-dealers can be mindboggling and broker-dealers are focused on meeting their contractual obligations with their largest buy-side customers. The International Swaps and Derivatives Association (ISDA) has come up with a standardized multi-step approach, but its variation margin protocol is reportedly cumbersome to follow.
Protocol Isn’t Easy
For starters, fund managers may be asked by broker-dealers or banks to exchange self-disclosure documents providing that will enable the broker-dealer or bank to identify whether the fund manager is subject to initial margin, variation margin or both, and which country’s rules apply. That’s the easiest requirement which could even be handled via email or telephone.
The more time-consuming element of contract negotiation is figuring out which of three methodologies established by the ISDA is optimal. The first “Amend” option requires the fund manager to change all of its contracts with all broker-dealer and bank counterparties to accommodate the new regulations, regardless of when the trades were settled. The second “Replicate and Amend” allows fund managers to retain the terms of contracts for trades executed before March 1 while using modified terms for new trades falling under the scope of the new rules. The third “New CSA” option requires entirely new contracts with new credit support documentation.
Although the “Replicate and Amend” option sounds like the most logical choice for fund managers, most prefer the “Amend” option. One reason: they may not want to deal with the legal and operational hassles of handling different rules for two sets of trades. The ones opting for the “Replicate and Amend” option likely want to retain more favorable terms for the contracts set under previous negotiations.
What about the new CSA choice? “Fund managers which are trading in over-the-counter derivatives for the first time will likely have no choice, but to select the new CSA option,” says Nelson. “Broker-dealers might also prefer the new CSA option, because it will give them the opportunity to implement more consistent rules across their contracts for both variable margin and other terms. The Amend option allows the fund manager to tweak its contracts only to the extent required by the new variable margin rules and retain the flexibility achieved in previous negotiations.”
The selection of either the Amend, Replicate and Amend or the new CSA option for setting the terms of variation margin contracts affect the questions fund managers then have to answer through a separate ISDA questionnaire. “The answers to the questions will then determine the terms of the legal contracts with broker-dealers and banks. Ideally, fund managers will match up everything they want with what broker-dealers want,” explains Froom. “When they sometimes don’t, there is a default option.”
Case in point: if the contract is governed under New York law, the default mechanism for the notification time is 10AM EST. The notification time is when the fund manager must be notified by the broker-dealer of a margin call to receive the margin on a certain day. Under New York rules, that’s the same day.
ISDA and IHS Markit have created an automated ISDA Amend platform which fund managers can use to address contractual changes with multiple broker-dealers and banks with a single effort. However, as swaps operations consultants tell FinOps Report, the “Replicate and Amend” option by its very nature is specific to each negotiation. What’s more the nature of the elections required to be handled through the ISDA questionnaire may differ depending on the fund manager’s underlying fund clients and the jurisdiction the broker-dealer or bank must comply with. “The premise of ISDA Amend is to allow fund managers to kill multiple birds with one stone, but covering an entire counterparty population typically requires multiple stones,” says one operations consultant. “The operational and administrative burdens of throwing each stone can be significant.”
Regardless of which country’s rules apply, fund managers must be able to transfer collateral within a day or so after they have received the margin call. That takes more than just automating the transfer of the cash or securities. Fund managers need to confirm that they can match up the number of transactions, the economic terms of the OTC derivative contracts and their daily valuation correctly. Any discrepancies will result in errors — either in the amount of collateral or the identification of the counterparty receiving it.
Ideally fund managers should optimize the use of collateral — that is, tie up as little value as possible to get the job done. So they need to understand the terms of each contract with each counterparty, know how much collateral they have on hand and where it is located. Cash will naturally be the easiest to handle operationally, but it will spell far higher funding costs.
Knowing one’s internal capacity can go a long way to making the right decision on how much of the collateral management process to retain inhouse and how much to outsource. Fund managers could decide to build their own collateral management systems, license third-party platforms, use managed platforms, or even outsource some or all of the functions to third parties. There are plenty of software vendors and custodian banks only too eager to help out with one or more tasks.
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