Fund Managers: Raising the Operational Bar for Uncleared Swaps

With regulators on both sides of the Atlantic wanting bespoke swaps trades to fall under new margin guidelines, fund managers can ill-afford to sit idly by and rely simply on the negotiating skills of their legal advisors to come up with the best terms possible.

Buy-side firms will need bring the so-called uncleared swap transactions into the same operational framework as those which are processed through clearinghouses — which act as middlemen of sorts — cautioned collateral management experts speaking and attending the International Swaps and Derivatives Association’s North American conference in New York on Tuesday. Hopefully, that framework is a seamless automated process. If it isn’t, fund managers will have their work cut out for them and time is running out.

While clearinghouses call all the shots for how much initial and variation margin is required for cleared trades — those which they must handle — regulators will now do so for uncleared swap transactions. Those are the ones which are processed bilaterally between fund managers and broker-dealers, outside of any clearinghouse. Regulators want counterparties in these bilateral, or bespoke deals, to also be protected from the potential their partners will go bust and in doing so avoid potential systemic risk. Counterparties will no long be allowed to make up their own rules which in some cases meant that transactions were either completely uncollateralized or no initial margin was used.

European regulators came out with their proposed rules last year, while Japan’s Financial Services Agency did so in July followed by the US Federal Reserve, Office of the Comptroller of the Currency and Federal Deposit Insurance Corporation last week. The new rules will be effective in December 2015 for variation margin for all fund managers, broker-dealers and most financial end-users — pension plans and other asset-owners. However, when it comes to initial margin, the rules will be phased in beginning December 2015 for the most active players — the ones with the highest notional value of swaps on their books –and ending in December 2019 for the smallest. Even so, there will be a minimum threshold of notional value required to fall under any initial margin requirements.

“Regulators are changing the nature of the relationship between fund managers and broker-dealers from one based entirely on bilateral negotiation to one partly based on standardized rules for collateral management,” says Nicholas Newport, managing director for London-based financial services consultancy InteDelta. “Such a scenario levels the playing field and reduces the potential for major discrepancies in how broker-dealers treat fund managers as to the amount of collateral required, the type of collateral and when it must be delivered.”

Naturally, regulators want to encourage market players to process more transactions through clearinghouses so they are making it far more expensive — collateral-wise — to trade and process bespoke or customized contracts. Still, by all industry accounts there will still be a sizable percentage of trades that will clear outside a clearinghouse- anywhere from 20 percent to 50 percent depending on risk appetite. Wanting to generate higher alpha and potentially earn higher fees, it is unlikely traders will do away with some exotic swap deals altogether.

Regulators will allow market players to calculate initial margin for uncleared swap contracts based on regulatory model methodology, but collateral specialists say it is cost prohibitive. Alternatively, they can use their internal models but without any granular guidance on how to do the math, fund managers and broker-dealers will naturally have to negotiate — or battle in many cases — whose interpretation will win out.

To reduce potential disputes — and stalemates — which could occur when fund managers and broker-dealers simply can’t agree on how much initial margin should be put up, the ISDA is coming up with its own standard initial margin model, or SIMM for short. “Firms typically rely on their own initial margin models but since the methodologies and inputs could vary, it isn’t an efficient process and could cost them more collateral than necessary,” says Athanassios Diplas, a New York-based senior adviser to the board of ISDA and head of an ISDA committee of buy and sell-side firms working on the initial margin model.

Similar to pricing models, the SIMM consists of the methodology — or mathematical equations– which would be used to calculate initial margin and the types of data inputs which must be incorporated. “While data inputs could vary between firms, a uniform model will reduce the number of discrepancies between fund managers and broker-dealers as well as the size of the discrepancies,” says Tomo Kodama, managing director at Bank of America Merrill Lynch. “Firms no longer have to worry about making their initial margin model match up or be consistent with that of their counterpart and what happens when they don’t.”

The ISDA is focusing its attention on calculating initial margin requirements, because the task is far harder to complete than for variation margin due to the subjectivity involved when forecasting the future value of the contract and the potential that one of the two counterparties could go bust. By contrast, the amount of variation margin reflects the changes in collateral required during the lifetime of the swap transaction. Therefore, it depends only on the value of the contract on a given business day.

The ISDA-led group is set to present an initial draft of its proposed initial margin model to US and European regulators — such as the US Fed, CFTC, European Banking Authority and European Securities and Markets Authority — next week and are hoping it will eventually win their blessings as the accepted global framework. “There are some last-minute adjustments or recalibrations to make. The most significant is accounting for the need to have sufficient initial collateral on hand to unwind a trade in a far shorter timetable, only ten business days,” says Oliver Frankel, managing director at Goldman Sachs. Current industry practice allows for up to twenty business days to unwind a trade, but regulators are taking a more conservative approach.

Just how different will the new initial variation model will be from what fund managers and broker-dealers use today? It all depends on how mature they are when it comes to collateral management and usage. “If they aren’t relying on initial margin today, it will obviously be a major change,” says Diplas. “For many who do use initial margin, but depend on their internal models, the difference will be far more minor.” The reason: they may already be using the sensitivity-based approach favored by banking regulators, which takes into account changes in interest rates and other market factors.

Just how much work fund managers will need to do to prepare for the new regulatory regime for uncleared swap trades will naturally depend on the sophistication of their current operational and IT framework.  Based on interviews with middle and back office operations specialists, IT managers and collateral management consultants, FinOps Report has distilled the following five step process fund managers should use to get prepared before the new rules come into effect.

1. Divide and Conquer

If a fund manager doesn’t know which trades should be cleared through a clearinghouse and which shouldn’t, it’s impossible to know how much collateral will be needed and when. Although European regulators are still working specifics of which types of swap trades must be cleared, clearinghouses have published lists of  the swap contracts they can accommodate.

“Armed with that information — and understanding the current collateral requirements — they can figure out how much collateral they will need,” says Anthony Perrotta, director of fixed-income research for research firm TABB Group in New York. “They can then do the math and compare that figure with what they might need for uncleared swaps and decide whether they even want to do an uncleared swap transaction if they can achieve the same end result — a hedging of risk.” Such comparisons, of course, are made more difficult by additional margin requirements imposed by futures commission merchants (FCMs), or  clearing brokers.

2. Review Existing Contracts

Current agreements between fund managers and broker-dealers might focus strictly on cleared swap trades and those which do address uncleared swaps might not address initial margin requirements. Even if they do they might not match the new regulatory requirements, so its best that fund managers go over just what the terms of those contracts are.

Among the critical provisions which must also be included in any revised contract is who will hold onto the collateral, and therein lies a difference between what US and European regulators are considering. Under US requirements, the collateral for uncleared swaps would have to be held by the fund manager’s custodian bank in segregated accounts. By contrast, European regulators are allowing broker-dealers to hold onto the collateral as long as they could ensure it would be “immediately available” in the event of a fund manager or broker-dealer ‘s bankruptcy.

3. Revisit Collateral Management Practices

While much of the attention on the new collateral rules for uncleared swaps centers on initial margin requirements, handling variation margin could also become problematic. “Regulators are requiring that only cash be used for variation margin and settlement, and that margin be delivered on the same day a margin call is made,” explains Michael Burg, vice president and product manager for the Derivatives 360 unit within BNY Mellon’s global collateral services business in New York.

That’s a big difference from the current industry practice under bilateral agreements of relying on securities for variation margin and delivering margin the day after a margin call is made. What’s more, the threshold for variation margin has been reduced to zero. Therefore, fund managers will need to collect or pay variation margin regardless of how little an amount is owed and to meet typical cash sweep deadlines, they will have to inform their custodians that they are delivering cash to meet a margin call on the morning of the day of the margin call. That’s far earlier than current practice of notification in the afternoon.

Bottom line: fund managers will need to rely on electronic means to confirm margin calls and to use SWIFT messaging to communicate with custodians, according to Burg, who co-chairs the derivatives working group for the ISITC, the trade group specializing in buy and sell-side operational workflow standards. Fund managers can no longer depend on faxes or phone calls to meet tighter service level agreements on the collateral management process that comply with the new regulatory guidelines. Naturally, it could all spell far higher operational costs to take into account more wire transfer fees and automation.

With an increase in the number of swap deals that must be collateralized comes the need for more reliable collateral optimization practices. To ensure the least amount of collateral and lowest cost assets for the initial margin are used, the fund manager must first know just how much collateral it has available, what types of assets or cash, where it is located, and the rules of each contract which depend on the broker-dealer and asset class involved. Such information is often held in multiple securities lending, repurchase agreements and over-the-counter swap applications.

“Ideally, a fund manager should consider a single collateral inventory system to store information on all available collateral and a single collateral documentation engine to store information on all securities transactions which require collateral such as the types of collateral which can be used, the worfklow process on margin calls between fund managers and broker-dealers, any fees, the party responsible for calculating collateral and how disputes will be resolved,” says Michael Barrett, director of collateral management for consultancy and outsourcing provider Genpact in New York. “Fund managers can no longer rely on tracking down the information in paper-based documents. The terms of those documents must be digitized and translated into rules for input into the documentation engine.”

Last but not least comes the number crunching. Rather than handling the math to come up with the optimal use of collateral after a trade is already executed, it should ideally be done beforehand as part of pre-trade analytics which would determine whether the trade is cost-effective, according to Thomas Severance, managing director at financial information services provider Markit in New York. Such analytics should also incorporate, to the extent possible, any additional fees charged by FCMs.

4. Review Data and Collateral Governance Policies

Calculating initial and variation margin correctly requires the correct data. The motto garbage in/garbage out applies so fund managers need to figure out where the relevant data is located and who will be in charge of ensuring its accuracy. If they don’t have a solid data management plan in place, they better get on it fast or they will risk potential miscalculations. Coinciding with such a task is creating a central data management unit overseen by a chief data czar to come up with uniform data models, data cleansing policies and access rules for each business line.

“With all swap transactions now having initial and variation margin requirements fund managers, which might have relied on operational experts in different business lines to make critical decisions on how how collateral requirements must be fulfilled, might find it best to unify the process in a single centralized collateral management department,” says Sonia Goklani, chief executive of Cleartrack, a consultancy in South Brunswick, NJ specializing in customized technology for clearing over-the-counter derivatives.

Just as fund managers are appointing chief data officers they might appoint a chief collateral officer to oversee the centralized collateral management process across multiple product lines. Of course, there would likely be some internal debate over jurisdiction. Experts suggest that he or she be independent of any specific business line and report directly to a chief executive officer. Such a role would incorporate trading, risk management, compliance and operations functions.

5. Consider Outsourcing

If doing all the work in-house is not feasible, it might be time to consider outside assistance. Some large custodian banks already provide either part or the full suite of collateral management services for uncleared and cleared swaps, as do third party providers such as Genpact which handles margin calls.

Markit, which already offers data, pre-trade collateral analytics and customized models for initial margin calculations, says it has received interest from customers to tweak its initial margin models to accommodate ISDA’s SIMM and to offer hosted services for initial margin calculations. “Many of our customers offer a full suite of collateral management services,” says Severance. “We complement those services by providing financial institutions with the analytics needed to properly manage their portfolios. If a firm chooses not to build the margin models and pre-trade analytics in-house, we can provide it with the tools necessary to achieve its goals.”

Regardless of what decisions a fund manager makes in how it will handle the new world of uncleared swaps, it is clear that it will need to involve multiple functional areas in the process: compliance, legal, IT, operations, trading desks and existing collateral management specialists.

“Fund managers can either stay in denial, resist change until the last minute, or get ahead of the curve and be ready to turn on the switch when regulators give the green light,” says Perrotta. Those who stay in denial or simply procrastinate may end up spending a lot more money and enduring a lot more grief — in the form of a higher number of unwound trades and poor relations with counterparties and regulators — than those who did their homework early.