02 Mar Standard Initial Margin Method (SIMM) Rules Are Final
STANDARD INITIAL MARGIN METHOD FINAL
The Standardized Initial Margin Method is now finalized. SIMM covers initial margin requirements for OTC (Bilateral ) contracts. This will mean firms dealing directly with each other will post the same amount of funds as every other client.
The mandate was to find a workable margin process which would allow derivative products to be more transparent, more liquid and find a level playing field from a credit standpoint.
HOW WILL THEY MITIGATE CREDIT RISK?
To equalize the credit risk between an AA counterparty and a BB counterparty, the banks will use other methods of risk mitigation:
- The maturity of the swap – higher credit longer swap
- The quantity of contracts the counterparty is permitted to enter
- Collateral Valuation Adjustment – the credit charge a customer pays when entering a swap will be larger for lower rated clients.
- Documentation – Annex A: i.e., specified entities, etc.
- Concentration Risk across product line with each counterparty
Validation is good for the soul. MHDS does use integrated (value chain) training preferentially with respect to derivatives reform. Why? Because derivatives reform has been so far-reaching, with so many interconnected changes retraining is necessary. Thats why we do it. But anyway, back to the margin rules.
Two good sources for information on the final margin rules:
- Sidley’s Derivatives Update dated January 20, 2016, has a summary and a PDF with details.
- If you’d rather read a concise overview, DLA Piper issued a press release here. With Initial Margin Rules final, let the training begin.
TRAINING THE VALUE CHAIN
With such widespread, overarching changes being made, training is essential. Unfortunately, most banks are structured in “silo” fashion, where each functional unit reports to its own line of business.
For example, documentation attends ISDA and Washington regulatory meetings but isn’t kept up to date on client product usage; new cost structures or even how the new ISDA Master Agreement is being received by corporate customers.
It makes more sense to train the derivatives value chain together. This will allow cross-discussion and networking to augment the training program.
OTHER’S AGREE, IT’S NOT JUST ME
On February 24, 2016 Derivsource published a blog by Olivier Grimonpont, “Dealers Prepare As Initial Margin Deadline Looms,” about the new margin rules coming into effect in September 2016. What interested me, even more, were statements about silo structure versus the need to value chain training.
Yep…right there…around two paragraphs down, Mr. Grimonpont writes:
“…The different departments within the bank will need to establish effective communication channels with each other, which may be a new scenario for some firms. Traditionally, many top-tier firms have been operating in a silo-based structure where OTC derivatives and collateral were managed independently from one another. In the new world, however, OTC derivatives and collateral need to work closely together.”
I’m happy to see other Derivatives Service Providers echoing my views. The past few years, financial institutions have invested a lot of time and money implementing Dodd-Frank (Title VII). It’s time to implement training programs to the rank and file. MHDS will use their Integrated Training Model to get the most out of the cross training necessary.
Integrated Training is a blended learning program MHDS developed in response to client needs post-implementation. The goal of value chain training (as opposed to intra-silo training) are quicker problem-resolution by double checking that proper redundancies are in place so each silo understands the impact of regulatory reform on their function.
THE SILO STRUCTURE
Most financial institutions (buy & sell-side players) have a silo organizational structure. There’s a good reason for silos. Silos separate functions and reporting lines, which create a layer of checks and balances necessary in a self-regulatory organization.
- The middle office and trading desk mark OTC derivatives books to market independently using different data sources
- The middle office will get rates for their MTM swap & option curves (swaptions and caps) from three different sources
- The trading book will receive checks against their own observation from interdealer brokers.
- But silos have a downside when it comes to hedging risk; the institution’s risk isn’t viewed in aggregate until you reach the consolidated reporting level.
- One unit could be long physical gold, another unit could be short gold derivative contracts. Net, the company is flat, but if each unit operates independently, each position is managed separately.
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STANDARD INITIAL MARGIN RULES FINALIZED
The past few years we’ve spent implementing & refining derivatives reform. Firms purchased software, hired CCPs and participated in compression processes. This year, regulations will continue to become effective. Like, the new rules on Initial Margin for Bilateral (OTC) Derivatives were recently finalized. There are two good sources for information on the final margin rules: Sidley’s Derivatives Update dated January 20, 2016 has a summary and a PDF with details. If you’d rather read a concise overview, DLA Piper issued a press release here. With Initial Margin Rules final, let the training begin.
SILO VS. VALUE CHAIN STRUCTURE
On February 24, 2016 Derivsource published a blog by Olivier Grimonpont, “Dealers Prepare As Initial Margin Deadline Looms,” Mr. Grimonpont writes:
“…The different departments within the bank will need to establish effective communication channels with each other, which may be a new scenario for some firms. Traditionally, many top tier firms have been operating in a silo-based structure where OTC derivatives and collateral were managed independently from one another. In the new world, however, OTC derivatives and collateral need to work closely together.”
All kidding aside, I’m happy to see other Derivatives Service Providers echoing my views. The past few years, institutions have invested time and money implementing Dodd-Frank (Title VII). With much of the heavy lifting behind us, it’s time for Integrated (Value Chain) Training.
Integrated Training is a blended learning program MHDS developed in response to client needs post-implementation. The goal of value chain training (as opposed to intra-silo training) are quicker problem-resolutions by double checking that proper redundancies are in place so each silo understands the impact of regulatory reform on their function.
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DERIVATIVES VALUE CHAIN TRAINING
MH Derivative Solutions, LLC offers clients a unique program that includes real-time examples and a blended learning process, which keeps participants interested. Having grown up in the derivatives market, McCabe has seen the business grow, stumble and change. Having worked on both buy side and sell side, she understands their respective operations. This depth of experience means she knows the function of every silo along the derivatives value chain.
GOALS OF DERIVATIVES VALUE CHAIN TRAINING
The goals of Integrated (Cross) Training is that each silo has greater understanding of the entire value chain. Particularly since the derivatives value chain has changed completely since 2010, Integrated Training is essential for smooth operations throughout the value chain. The organization is still structured in silos and their reporting lines remain unchanged.
The diagram below shows a typical derivatives workflow where Derivative Sales is the point person for derivatives with the client. Different organizations will have a different workflow. But generally, the salesperson is responsible for KYC (Know Your Customer) and AML (Anti-Money Laundering) regulations. A good senior salesperson is the first line of defense, protecting their institutions. But the Sales & Trading areas count on many other operational and technology areas of the institution.
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At the end of Integrated Training, each functional silo will know the derivatives value chain from start to finish and have a greater understanding of:
- Their role in the value chain
- The role of other functional silos with respect to derivatives
- Reasons why your institution made the decision it did with regard to reform regulations
The depth of understanding of each individual’s role within the value chain helps institutions provide better service to their clients because each functional silo can incorporate other areas. Better-serviced clients are happy clients. And happy clients…DO BUSINESS!
I wanted to give a hat tip to Derivsource and Mr. Grimonpont’s blog to illustrate like minds among derivatives service providers. It wasn’t meant to be a marketing pitch. But it sure does look like one. Well, if it quacks like a duck…make duck l’orange.
The takeaways for 2018 are:
While implementation continues, start educating all silos on new systems and workflow processes. Since these systems reside in different silos, Integrated Training can also be used to also assisted firms to determine how they can get Straight Through Processing (STP).
By educating each functional area, they can troubleshoot problems quickly; ensure redundancies exist and be able to coordinate quickly as the regulators make changes in the future. Finally, it will give the more creative people the chance to resolve some of the remaining issues or disconnect still being handled by hand. It’s win-win.
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Globally, Derivatives Regulatory Reform is uneven at best. It may be some time before the entire globe is working with the same margin levels and capital charges. Integrated Training is not static. Rather, it’s a dynamic process where new changes are incorporated as they become final.
Well, that’s it for me. I’m going to go out into a glorious spring-like afternoon and enjoy the day and hope you do the same. If you’d like to know more about Integrated Training, contact MHDS.
FOOTNOTE: Credit lines are an important part of a trading relationship. Even though initial margin will be posted and contracts will be marked-to-market daily. Whether the position is held by a clearinghouse or the bank (as a bilateral contract) there is still counterparty risk, Concentration Risk, Key Person Risk, Operational Risk, Liquidity Risk, for the most part. Therefore banks will assign limits for each client whether the trade is cleared or not.