US banking regulators might not have directly overseen the activities of fund management shops in the past, but when it comes to uncleared bilateral swap contracts, that stance is changing fast. The new arrangement will come at a hefty cost for heavy users of the bespoke deals.
Under final rules released October 22, a host of regulatory agencies are overseeing new margin requirements for uncleared swaps. Depending on the counterparty, the Federal Reserve System, the Office of the Comptroller of the Currency, the Federal Deposit Insurance Corporation, Farm Credit Administration and the Federal Housing Finance Authority will have authority to require initial and variation margin for uncleared swaps contracts. Generally, fund managers enter into uncleared swap transactions with banks, rather than broker-dealers. The banking authorities categorize fund management firms — typically US investment advisers or US registered investment companies — as financial end users, putting fund managers into the regulatory crosshairs.
By definition, uncleared swap transactions are those which aren’t cleared through a clearinghouse acting as middleman. Such contracts account for an estimated 39 percent of all swap deals.
Of the two types of margin detailed in the new rules, initial margin is considered the most difficult to calculate and operationally administer, because it is meant to buffer a potential counterparty default. The fund manager’s changing status regarding eligibility trading thresholds may also alter how much initial margin is required. By contrast, variation margin reflects changes in collateral required over the lifetime of the swaps contract reflecting the value of the contract on any given day.
The good news: the US banking regulators appear to have aligned their rules with non-US requirements. The US Commodity Futures Trading Commission (CFTC) is also expected to come up with similar requirements by year end, according to legal experts predict. “Fund management firms whose counterparties are banks will fall under the prudential regulators jurisdiction while those whose counterparties are broker-dealers will fall under the CFTC’s requirements,” explains Andrew Cross, a partner with Perkins Coie in Washington DC.
The Basel Committee on Banking Supervision (BCBS) and the Board of the International Organization of Securities Commissions released their requirements for initial and variation margin for uncleared swaps in September 2013. They will also become effective as of September 2016.
The other good news: US banking regulators provided significant relief from the margin requirements by increasing the threshold — or level of swaps trading — that financial end users and their banking counterparties must reach before they must comply with the new margin rules. From their previous suggested threshold of US$3 billion of average daily aggregate notional amount of swaps activity, the regulators have raised the three-month aggregate threshold to US$8 billion.
The regulators also expanded the type of collateral that can be used for variation margin from US-dollar cash to non-cash assets such as liquid securities and other “major” currencies, subject to haircuts. Fund management firms can avoid putting up any collateral on a contract as long as the amount of margin required doesn’t exceed US$500,000.
Another bit of relief from the earlier proposed rules is a change in the definition of affiliate, which directly affects the threshold calculations. Now, instead of requiring that one company have a 25 percent ownership stake in the other for the other to be considered an affiliate, a company is considered an affiliate if it does its financial reporting in the same consolidated financial statements. No longer will an affiliate have to be another company “controlled” by the initial company.
“The change in the prudential regulators rules will reduce the number of entities from which swap entities must post and collect initial margin and level the playing field between swap entities subject to US rules and those subject to the rules of foreign jurisdictions, such as the European Union and Japan, which have more closely followed the BCBS and IOSCO framework,” says Julian Hammar, an attorney for Morrison & Foerster in Washington DC during a recent conference on regulatory compliance hosted by the firm’s New York office.”The change in the definition of affiliate will make it easier for companies to determine whether, for example, a financial end user has material swaps exposure.”
The bad news: fund management firms will still have to post initial margin, if they didn’t beforehand, as long as they meet the “material swaps exposure” and threshold requirements. Almost always, fund management firms will have to post variation margin. The US$8 billion threshold only applies to initial margin requirements.
As in the proposed rules, US fund management shops still won’t be exempt from the rules, just because their counterparty happens to be a foreign bank. If the trade is executed through a US branch office of the foreign bank, it will be subject to US rules. Foreign fund management firms — those domiciled overseas — will also have to comply with the rules as long as their trades are executed with a US bank.
Still, fund managers appear happy that US regulators will be in sync with foreign ones. “The Asset Management Group of the Securities Industry and Financial Markets Association is pleased regulators are working together to align some margin requirements for non-cleared swaps,” says Laura Martin, managing director and associate general counsel for the AMG in a statement issued to FinOps Report. “Asset managers hope this alignment along with substituted compliance allows for the continuance of cross-border transactions and they are currently assessing the impact of the new US standards on their US operations.”
US banking regulators will allow a foreign bank that has a US fund management firm as its counterparty to follow a foreign regulator’s rules for initial and variation margin as long as the US regulators agree that the foreign rules are comparable to the US ones. The foreign bank’s obligations must not be guaranteed by a US entity. In the case of US bank doing business with a non-US fund manager, US banking regulators will only allow the “substituted compliance” to apply to the initial margin the US bank must post to the non-US fund manager. Neither counterparty can have its obligations guaranteed by a US entity. However, convincing US banking regulators that foreign rules are as good as US ones will be hard, warns Hammar.
Pay for Risk
The bottom line: fund management firms that once thought they would have far easier requirements for handling uncleared swaps than cleared swaps — or those processed through a clearinghouse — won’t. They may have eliminated the clearinghouse middleman from the equation, but they will have to come up with higher initial margin requirements for uncleared swaps than for cleared swaps. The reason: regulators want to dissuade fund managers from trading bespoke swaps in favor of standardized cleared swaps, because of the perceived increased counterparty risk involved with uncleared contracts.
Buy-side firms using bespoke instruments will still need to track down the necessary collateral, make certain it is the right amount and type of asset, and make certain that the new collateral requirements are included in their swap agreements with counterparties. Just how different the new operational landscape will be from the status-quo is unclear. At minimum, it appears they will have to review some of the margin arrangements they already have with bank counterparties.
“Depending on the bank counterparty’s evaluation of the risk of the fund management firm, the fund management firm may have already been posting initial and variation margin, even if it wouldn’t meet the material swaps exposure requirement,” says Cross.
Getting ready for the new rules will be a multi-step process, say legal experts. First, the fund management shop must prepare to continually monitor whether it must follow or will be exempt from the initial margin requirements. Just because the fund might initially be exempt doesn’t mean that will always be the case. The more swap contracts it trades, the more likely it is to tip the scale in favor of regulation. When the fund management firm does pass the material swaps exposure threshold of US$8 billion and must follow the new rules, it will have to do so only with regards to new swap contracts executed after the effective date applied. The contracts executed before the effective date of the regulations will remain exempt.
However, if the fund management firm eventually falls below the $8 billion mark, it will be allowed to follow the less strict initial margin requirements for new and old contracts alike. “Initial margin would no longer apply with respect to all outstanding swaps,” explains Hammar.
Still, that doesn’t necessarily mean the fund management firm can get its initial margin back. The fund manager can ask the bank to return the initial margin previously posted, but the bank counterparty isn’t required to return it. “The rules state that the swap entity may comply with the less strict requirements if the counterparty changes status. The rules don’t say they must do so,” says Hammar.
Once the fund management firm has determined that the new rules apply, it can’t assume it will agree with bank’s calculations for initial margin. Although the banking regulators ruled that it is up to the bank counterparty to make the computation, unless the bank and are fund management are using the same methodology and inputs their figures will differ.
The prudential regulators have called for either a table-based system, suggested in the rules, or an internal model-based approach. Although industry consensus is that the table-based system will likely create higher initial margin requirements than model-based approach, regulators have not specified what methodology or inputs they want use. So financial firms are left to create either proprietary margin models or rely on an industry-endorsed one such as the standard initial margin model (SIMM) offered by the International Swaps and Derivatives Association (ISDA).
There is no industry consensus on just how much leeway fund management firms should give their banking counterparties when deciding whether to dispute the initial margin requirement. A few hundred or even thousand dollars might not matter that much for a single transaction, but multiple small differences could add up to a sizable amount over time.
“The fund management firm and bank counterparty will likely have to agree in their contracts on just how much of a variance in initial margin calculations each party will accept before escalating the discrepancy into a dispute which must be resolved,” says Cross. “The agreement must also include language on how the margin dispute will be resolved.”
Even if fund management firms agree to whatever initial margin their bank counterparties want, that doesn’t mean they will have sufficient cash or the right securities on hand to pay it. That is where collateral transformation and optimization comes into play. In a worst-case scenario, the fund management firm will have to transform — or exchange — the lower-grade collateral for higher-grade collateral, often at a deep discount. This tradeoff could either be handled by the fund shop on its own or through a transformation agent, such as a bank or broker-dealer. The third-party might handle either the entire collateral management process or just the transformation work.
Cleaning the Closets
Because of the high costs of collateral transformation, fund management firms might want to dig deeper for the high-quality collateral they may already have on hand. This may require elimination of the boundaries between siloed collateral management applications for different business lines — futures, swaps and securities finance — in favor of a single all encompassing collateral optimization platform, say collateral management experts. This platform would include or be integrated with an enterprise collateral inventory system and a single documentation system detailing the asset class and the rules of each transaction requiring margin.
While there are plenty of collateral management platforms available for licensing, not all are capable of handling every asset class, warn collateral management technology experts. “Fund management firms must pay close attention to the functionality of the collateral management platform and do extensive testing before investing,” one fund management IT director tells FinOps. “It is a buyer-beware market.”
Given that initial margin is likely to be higher for uncleared swaps than cleared swaps, fund management firms will need to decide if they want to continue entering the bespoke contracts or rely on cleared swaps or even futures contracts to achieve the same investment objectives. Such an analysis will need to include not only the margin requirements of each type of contract but trading and clearing costs through futures commission merchants and clearinghouses as well. Collateral management specialists tell FinOps that doing an apples to apples comparison won’t be all that easy, because of the multitude of fees which must be considered.
Although it might seem that middle office executives would have the most work to handle when it comes to uncleared swaps, compliance managers and legal department directors won’t be far behind. They will be busy changing dozens if not hundreds of master swap agreements which may never have cited which securities will be eligible for margin and how it will be calculated. “We’re talking about more than just one or two paragraphs in each ISDA master agreement,” explains James Schwartz, an attorney with Morrison & Foerster in New York. Published by ISDA, the master agreement outlines the standard terms applicable to an over-the-counter derivatives transaction between two parties.
What’s more, says Cross, fund management firms that were already posting initial and variation margin may well end up having to renegotiate those contracts with their bank counterparties. “The fund management firm and bank will have to decide whether they will change the threshold of the initial and variation margin that must be reached for the margin to be paid. If the figure agreed to in the existing contracts was below the US$500,000 minimum transfer amount cited by the prudential banking regulators, the fund management firm will want to push back to allow the figure to be raised to US$500,000,” explains Cross.
“However, the bank doesn’t have to agree,” he adds. “The banking regulators only said that any margin over US$500,000 must be collected by the bank from the fund manager. They don’t tell a bank what to do when the margin is under US$500,000.”
Who will end up the winner in these tugs of war? As is often the case in relationships between fund management firms and sell-side counterparties, the fund management firm could win its demands — if its business is sufficiently lucrative for the bank. Nevertheless, two collateral management directors at US banks tell FinOps that their banks will likely not agree to lower the “way higher” regulator-suggested threshold. “The initial margin we charge is based on the risk profile of the fund management firm. If we are not legally obligated to loosen our standards, we won’t,” says one.
Fund management firms, recommends Cross, should also expect to review their triparty control agreements with custodian banks. “Existing regulations that apply to US mutual funds already require funds to use a control agreement, so that all margin posted by the fund with respect to the swap contract remains under the custody of the fund’s custodian bank,” says Cross. “However, the US bank regulators are now requiring that any collateral posted with a bank as initial margin may be held by a custodian bank in a segregated account, or an account separate from the custodian’s own funds.”
While fund management firms try to figure out the steps to meet the new requirements, their operations, compliance and technology experts will likely be spending some long nights and weekends ironing out their roles. As happens with other risk management regulations, affected fund managers can expect the regulators to be keeping a close eye on what they do and how they do it.