On 3 April 2020, the Basel Committee on Banking Supervision and the International Organization of Securities Commissions (BCBS/IOSCO) announced an extension of Phase 5 and Phase 6 of the Uncleared Margin Rules (UMR) to 1 September 2021 and 1 September 2022, respectively, in response to COVID-19. With Phase 5, firms with aggregated average notional amount (AANA) of OTC derivatives exceeding US$50 billion (if under the US regime, a different threshold applies under other regimes) will be required to exchange initial margin with counterparties for non-centrally cleared derivatives. That will be lowered to US$8 billion (if under the US regime) when Phase 6 takes effect.
While relatively few firms in the Asia-Pacific region came under the purview of phases 1 to 4 of the UMR, a large number of buy-side firms in the region could fall under the thresholds of phases 5 and 6. Purtini Joshi, a collateral management executive at DTCC, provides a broad overview of the current situation.
How prepared is APAC for UMR Phases 5 and 6?
Preparedness across APAC is somewhat low. Although this regulation came into force in 2016, the rules have not been implemented across the region in a harmonized manner.
Jurisdictions like Japan, Australia, Singapore and Hong Kong implemented the rules quite early and in line with global timelines.
Other countries like South Korea, Taiwan and India have introduced these rules more slowly. One of the reasons for this is because counterparties in these countries tend to be smaller, so their exposures are smaller. While implementations are underway, these countries are moving ahead on their own timelines.
Countries who are in the earlier stages of implementation of these rules include China and Indonesia, among others.
At the same time, some financial services firms across Asia are still not sure whether they are going to cross the thresholds of Phase 5 and Phase 6 and fall under the purview of these rules.
Why have some firms not yet determined whether they will fall under these margin rules?
It is a fairly complicated exercise to determine whether a firm is in scope, for a number of reasons. First, the rules apply at an entity level, so if you look at buy-side firms, these rules apply at the asset owner level. They need to have a consolidated view of where their holdings and trading relations are. An asset owner could have multiple investment managers trading on their behalf. They need to be able to take a consolidated view of what their relationships are in relation to the OTC rules.
Second, the concept of initial margin is new to some firms, who may have never exchanged initial margin. For some, it is a question of not having the knowledge. For others, it is a prioritization effort because they are not immediately impacted. Others indicate they might be able to stay outside scope by not reaching those thresholds.
What are the potential implications of not being prepared for UMR Phase 5 and Phase 6?
Even if your home jurisdiction has not implemented these rules, you may still be required to meet the obligations because your counterparty is exposed to these rules. As a result, one counterparty may decide that it is too risky to trade with a firm in APAC because the APAC counterparty is not UMR compliant
When the APAC counterparty is unable to trade, it could add more risk to their positions. A lot of these contracts tend to be hedges, so it could create a further risk within their portfolio if they don’t have these contracts in place.
Can firms get up to speed in a short amount of time?
Unfortunately, this will not be a short process because there are three broad steps – documentation, technology and operational considerations – that must be addressed to be compliant with these rules.
First, consider if you’ve got UMR-compliant legal documentation with your counterparties. The documentation process typically includes negotiations of contracts and understanding what sort of collateral is going to be pledged in segregated accounts for the initial margin. Being able to get a complete handle on this can be a significant undertaking. The contractual framework for meeting IM requirements is time consuming as account control agreements between both parties’ custodians need to be in place as well as bilateral IM credit support agreements.
The second pillar is the methodology, technology and the systems that are required to calculate initial margin. Whereas variation margin is a simple market-to-market exercise that firms in APAC are familiar with, initial margin is different because it is gross and cannot be netted between counterparties. Both parties need to calculate their exposure for initial margin independently of each other. It takes a fair amount of time for a firm to build the expertise inside the organisation to model the ISDA Standard Initial Margin Model (SIMM) if firms are not deciding to use the regulatory prescribed schedule methodology (also known as Grid). Firms need that expertise or technology to be able to calculate and exchange initial margin. The industry has built innovative solutions that provide firms with tools and expertise for automating the initial margin processes from margin agreement down to settlement. Firms would benefit immensely by leveraging these solutions to build capability and reduce risk of non-compliance.
The third pillar is centred around operational considerations and requirements. Initial margin is fairly onerous in terms of what collateral you are going to use and how quickly you need to post it. In addition, collateral that is posted needs to be held in a segregated account. Operationally speaking, a host of measures are needed for compliance.
For example, in some jurisdictions, collateral needs to be settled T+1. If you are trading with a counterparty in another market, then you need to be able to settle that collateral within the settlement period of the jurisdiction your counterparty is governed by.
During Covid-19, markets were very volatile, and that was the point when some of these firms felt the increased stress of managing these processes operationally. Automation, efficiency and preparation across the collateral management process is key to ensuring you are prepared for the next market event while achieving compliance with forthcoming mandates.
