With the fifth phase of initial margin requirements for uncleared swap transactions recently effective, collateral management and compliance managers at hundreds of fund management shops need to start preparing for the final phase of uncleared swap rules to avoid finding themselves in hot water with regulators or counterparties, warn operations and legal experts.
Fund management shops falling under the September 1, 2022, timetable for Phase six of UMR, short for uncleared margin regulations, will have the steepest learning curve because they have smaller trading volumes and have never pledged initial margin (IM). Even if they did it was not under a regulatory mandate. At a minimum. without the right operational and legal infrastructures in place, fund managers may not be able to trade with counterparties which won’t want to violate UMR. Mistakes can cause the fund manager to either not pledge initial margin or pledge the wrong amount of initial margin. The largest most technologically sophisticated broker-dealers and banks fell under the first five phases of UMR, beginning in September 2016, because of their higher trading volumes. Phase five of the UMR took effect on September 1, 2021, Over 700 fund management firms are expected to fall under Phase six, which impacts those whose average aggregated notional amount (AANA) of uncleared swap contracts comes to over US$8 billion.
Unlike variation margin (VM), which is meant to address fluctuations in the daily value of an uncleared swap contracts, initial margin (IM) is intended to protect against a counterparty’s default or bankruptcy. Global regulators designed a phased approach to complying with the UMR after the financial crisis to reduce systemic risk by reducing the number of bespoke bilateral transactions not processed through a central clearinghouse. Their goal was to have as many swap trades processed through clearinghouses which would take on counterparty risk. IM is more difficult to calculate than VM and there are more stringent contractual obligations to follow. Although the UMR’s rules are similar across the globe, fund managers doing cross-border business need to keep subtle national variations in mind particularly if they have to follow UMR outside their home market.
For fund managers wanting to get a head start preparing for UMR’s Phase six, operations, technology and legal experts contacted by FinOps Report devised the following five-step approach with recommendations on how to avoid landmines along each step of the way.
Sort: By now fund managers should have an inkling of whether they belong to Phase six or not. All they must do is calculate the AANA and the timeline used depends on the regulator. The US Commodity Futures Trading Commission wants the months of March, April, and May of 2022. Fund managers must also know which OTC derivative contracts to include, because there are a few differences among the US, European, and Asian versions of UMR. Equity options are included for AANA under Japan’s UMR, but not under the US UMR. If the wrong contracts are included or omitted, the calculation of AANA will be incorrect. “Fund managers should do their AANA calculations earlier than the designated months to have sufficient time to plan for the September 2022 deadline and potentially change their trading strategy to reduce the potential they will fall under Phase six,” recommends Jonathan Spirgel, managing director of collateral and Treasury management technology firm Hazeltree in New York. “Fund managers must calculate AANA based on each legal entity, which is typically each fund.” Hazeltree’s AANA estimator calculates AANA daily to warn firms when they need to start preparing for UMR.
Calculate: Once fund managers know whether they fall under phase six, they must notify their counterparties and decide how they will calculate initial margin. There are two approaches to measuring IM, each of which has pros and cons. The risk-based standard initial margin model, known by the acronym SIMM and devised by the trade group International Swaps and Derivatives Association, has regulatory acceptance on both sides of the Atlantic. The other, called grid or IM schedule, is based on a percentage of the notional value of uncleared swaps.
SIMM appears to be the preferred approach to calculating IM among broker-dealers and banks, which have been pushing their fund manager counterparties to use that methodology. However, a fund manager will want to pledge the least amount of collateral so it will need to calculate IM based on the SIMM and grid methodologies before deciding which one to use. As a rule of thumb, the more complicated the trading strategy, the more likely the SIMM methodology will generate a lower margin requirement than the standardized grid model. Managers of less diversified portfolios with longer dated positions will likely prefer the grid model.
The final result isn’t the only factor fund managers must consider when making a choice between the SIMM and grid approaches. “The decision-making process comes with a tradeoff. The risk-based SIMM model might generate a lower margin requirement in a lot of cases, but it is more difficult to use than the standardized grid method because it is more data and calculation-intensive,” explains Cristina Grigore, director of derivatives data and valuation services at swaps data giant IHS Markit. “Therefore, fund managers need to be prepared for additional data retrieval and management costs.”
Although the SIMM is touted as a standard model, results may vary between counterparties. There is no standard way for how risk sensitivities must be calculated, and market data may not be consistent between trading partners. “Counterparties should test the use of their use of SIMM to ensure they reconcile their differences in margin amounts,” recommends Grigore. Fund managers worried about whether they can pull off the right calculation can rely on one of several dozen vendors which have passed ISDA’s muster. Among those are IHS Markit and TriOptima whose applications feed IM figures into Acadia’s IMEM (Initial Margin Exposure Manager) system for reconciliation and dispute management.
Transactions that have an independent– or voluntary– amount of collateral agreed between counterparties must be considered when calculating margin and there are three methodologies from which to choose. The first, called the distinct margin flow approach, requires the separate posting of both IM and independent margin. Although it may be the easiest to implement, it is not favored because it requires a higher value of collateral to be pledged. The other two approaches require the same amount of collateral to be pledged but have operational differences, explains Ilene Froom, a partner in the financial practice of the law firm of Reed Smith in New York.
Under the “greater of margin flow” approach the fund manager will pledge either the IM under UMR or the independent amount depending on which of the two is the larger amount; the amount is pledged to a custodian bank to be held in a segregated account. Under the “allocated margin flow” approach the IM is pledged to the custodian and the independent margin is reduced by the amount of initial margin. If there is any independent margin left over it is not pledged to a custodian bank for a segregated account, but is held by the counterparty swap dealer. “The allocated margin flow method will allow the swap dealer to keep some of the collateral on hand and be able to rehypothecate it rather than have it segregated at a custodian bank,” says Froom. Therefore, that methodology may be favored by banks and broker-dealers, but may not be favored by some fund managers because of the operational challenge involved in establishing two transfers of collateral.”
Operate: Once the IM calculation is made, it’s time for even more hard work. Under the US UMR, a fund manager does not have to pledge collateral unless the amount comes to over US$50 million. If the figure is over US$50 million, a fund manager will need to figure out what type of securities it will pledge and transfer those securities to a segregated account at a custodian bank. Cash can legally be pledged as collateral, but because it must be reinvested in liquid assets quickly it is not practical to do so.
Fund managers will rely on internal or third-party systems to calculate IM, value collateral, and transfer the correct collateral. “Fund managers also have to agree with counterparties as to what amount below US$50 million will trigger the need to post collateral, Each bank or broker-dealer could come up with a different requirement as the US$50 million figure is a maximum threshold,” says Thomas Griffiths, head of product for margin and collateral analytics provider Cassini Systems. “Ultimately, the fund manager wants to ensure that it either won’t pledge collateral unnecessarily or won’t inadvertently need to pledge collateral because the counterparty’s UMR threshold was breached.”
Paper: Fulfilling the UMR requires plenty of documentation. Fund managers and their counterparties must sign initial margin credit support annexes (CSAs) or initial margin credit support deeds (CSDs) with each counterparty which will contain the relevant terms. Those include which methodology each will use to calculate the margin requirement; notification times; the threshold for each party (which has to comply with UMR and be considered by a party and its margin affiliates); the eligible collateral; and haircuts. The terms the parties elect in an IM CSA or an IM CSD have to comply with relevant uncleared margin rules. A separate account control agreement must also be signed among the fund manager (for its client); the swaps dealer and the client’s custodian bank and the swaps dealer; the fund manager (and its client) and the swaps dealer’s custodian bank for collateral to be segregated at the custodian banks. “Some hedge fund managers previously pledged independent — voluntary– collateral but that was typically held by the counterparty and not in a segregated account,” explains Spirgel.
The account control agreements can be either third-party and tri-party. Third-party contracts involve the custodian bank simply holding onto the collateral in a segregated account on behalf of the pledgor or pledgee and taking direction as to which collateral to transfer. Tri-party agreements require the custodian bank to pick which securities held on behalf of a fund manager or broker-dealer will be transferred as collateral. “In deciding which of the two types of agreements to choose, fund managers will need to weigh the higher cost of a tri-party agreement with their own operational resources,” says Don Macbean, a partner in the structured finance practice of the law firm of Katten Muchin Rosenman in New York. “Technologically sophisticated fund managers that are capable of handling the collateral management work on their own may opt for the third-party model.” So far, from what US fund management firms tell FinOps Report. most will rely on the tri-party model, also favored by broker-dealers.
Evaluate: Fund managers can make the best trading strategies knowing the amount of collateral they must post ahead of time. The cost of collateral comes to a “funding cost” which translates into the cost of finding the collateral. Case in point: bonds used as collateral are typically found through a repo agreement in which the fund manager must give the counterparty an interest payment. As a rule of thumb, the more liquid the asset used, the lower the haircut but the higher the funding cost. “Based on the funding cost, a fund manager could decide to either not execute a transaction, change its trading strategy, or select a different counterparty for the same transaction,” says Cassini Systems’ Griffiths.
Most collateral management systems can provide a workflow for consuming an amount of margin and transferring this margin to another account. However, they do not calculate the funding cost until after the fact– when the deal has been completed — at which point the fund manager cannot make any changes. Cassini Systems lays claim to being the only margin and collateral analytics system to bring post-trade data into the pre-trade process on a real-time basis. Cassini’s system links to the order management system of Charles River, now part of State Street, as well as to BlackRock’s portfolio management system Aladin to help fund managers more effectively handle their margin during the lifecycle of the derivatives transaction. Cassini’s application also connects to SimCorp’s IBOR platform to allow pre-trade orders from the Simcorp application to flow into Cassini’s calculation engine.
Among all the steps needed to comply with UMR, the ones worrying compliance managers and collateral operations experts the most are having the right warnings about potential thresholds to avoid posting initial margin and drafting the right contracts. “Fund managers will likely use the US$5 million or US$6 million AANA mark as an early warning sign for when they must consider themselves as part of UMR’s Phase six because it will be easy to reach the US$8 million threshold,” says Griffiths. “The largest banks and broker-dealers will typically create their own pre-trade analytics applications to keep track of when they might exceed a threshold, but fund managers with fewer resources will likely have to rely on manual interactions between trading and collateral management desks unless they depend on an automated system such as Cassini’s.”
Finding a third-party or triparty custodian won’t be a difficult as some of the largest custodian banks — BNY Mellon, State Street, JP Morgan, and Citi– are offering services for account control agreements. The bigger challenge will be agreeing on the wording of the account control agreements which could take anywhere from several months to over a year to complete. “The account control agreements need to be phrased correctly to avoid any interpretation by custodian banks as to the rights of the pledgor and pledgee,” says John Hunt, a partner in the investment management practice of Sullivan & Worcester in Boston. Working out CSAs can also be tricky. “Fund managers with lower uncleared swap trading volumes will find it harder to push back against the demands of broker-dealer and bank counterparties,” says Hunt.
When it comes to sorting out contractual lingo, operational capabilities should be taken under consideration. “Some swaps dealers will ask counterparties to change the termination currency because of the foreign exchange haircut and fund managers also need to ensure they can accept the proposed eligible collateral the bank or broker-dealer wants the fund manager to use to close out a contract,” cautions Froom. Liquidity varies by asset type.
Ultimately, regardless of how a fund manager decides to fulfill any of the five steps in preparing for Phase six of UMR it must remember that time is not on its side. Because broker-dealers and banks will have to deal with several hundred rather than several dozen relationships as was the case in previous phases, negotiations could be delayed. Froom urges that fund managers which think they will be in Phase six of UMR avoid potential trading disruptions due to the limited resources of banks and broker-dealers by starting the documentation process as early as possible.
Fund managers will also face first-time operational requirements so they must test any application upgrades or new applications before they are used. “Firms need to plan for the worst and ensure they have everything in place and then hope for the best, which will mean not having to exchange IM,” says Helen Nicol, head of product for London-based collateral management system CloudMargin. “The days of spreadsheets are over, and regulators are expecting to see the appropriate controls in place.”