The Challenges of Phase Five Initial Margin

06 Sep The Challenges of Phase Five Initial Margin

On September 1, 2019, Phase 4 brought 23 new groups posting Initial Margin for Uncleared Derivatives. Phases 1-3 brought 20 groups. Today, we have a total of 43 entities posting Initial Margin.  On July 9, 2019, in response to industry concerns about readiness, regulators changed the threshold for Phase 5 and added a 6^th Phase-in for Initial Margin for Uncleared Derivatives.  This will give the industry time to meet the challenges of Phase Five Initial Margin.  

New Phases for Initial Margin for Uncleared Swaps

• Phase 5 threshold now covers entities with more than $50 billion in Average Aggregate Notional Amount (AANA)
  • Observation Period: June 1, 2019 – August 31, 2019
  • The deadline for Initial Margin is September 1, 2020.

• Phase 6 threshold now covers entities with more than $8 billion in Average Aggregate Notional Amount (AANA)
  • Observation Period: March 1, 2020 – May 31, 2020
  • The deadline for Initial Margin is September 1, 2021.

Entities Expected in Phase 5 & 6

Phase 5 will bring an estimated 200 entities & Phase 6 500 entities are expected to come into scope next year. Given the large increase in entities, this article discusses the challenges of Phase 5 initial Margin for Uncleared Derivatives.

Focus on the areas tasked with handling the heavy lifting. Use the flow chart in the appendix.    The trick to meeting the challenges of Phase 5 & 6 is to have a game plan agreed to by all relevant parties and begin the process early. 

This article and the attached Roadmap illustrate the decisions for Phases 5 & 6 initial margin and show which business unit will face those challenges.  Consider the roadmap a “Skeleton Key” for Phases 5 & 6. 

Tasks & Tips by Job Function

Compliance Manager

Compliance will lead the charge to determine if the firm is in scope.  Assess if the firm can comply with posting initial margin on uncleared derivatives

TASKS & TIPS:

• •Calculate AANA for Phase 6 from March-May 2020
  •  Deadline for posting IM September 1, 2021
• Counterparty Schedule: see schedule attached
• Post-Settlement Obligation: reprice collateral and post/receive collateral
• Make sure to check collateral eligibility to avoid Wrong Way Risk

Legal Counsel & Documentation

Agree on Legal Documentation: from custody agreements, and account control agreements to eligible collateral schedules.  Negotiating documents always take much longer than expected: start early. 

TASKS & TIPS

• Sign new collateral & trading documentation w/ every derivatives counterparty or use a collateral manager to renegotiate.
• New collateral schedules w/ counterparties
• If a task can’t be completed internally, try online schedule managers like RULE.
• Margin Calls: Decide to Use SIMM or Schedule Based (advise CP’s when you decide)

Head of Operations

Conduct a frank appraisal of your internal capacity to manage the collateral process or whether you need to outsource to a third party.

TASKS & TIPS

• Make sure y0u have the ability to receive Initial Margin
• Build or buy the software to Deliver/Receive collateral
• Confirm the accuracy of margin calls received
• Check the eligibility of the specific collateral posted or received
• Counterparty Schedule: see attached example
• Segregation Options:  Third Party or Tri-Party, choose the custodial arrangement
• Post-Settlement Obligations: monitor IM and adjust the amount of margin posted
  • There are Margin Solution Providers for Tri-Party Arrangements, such as BNY-Mellon, JP Morgan, Clearstream & Euroclear

Risk Manager

Responsible for minimizing risk throughout the margin process, spotting potential trouble spots and putting robust controls in place so everything works from end to end.

TASKS & TIPS:

• Custodian Selection: Which service do you need?Tri-Party or Third-Party?
• Counterparty Schedule: See form attached
• Segregation Alternatives: Structure for segregating Initial Margin and how it will be repriced, settled, etc.
• The rules for Segregation of Initial Margin were updated in May 2019 to prevent the administrative backlog
• Counterparty Matching
• Post-Settlement Obligations:  Repricing collateral and changing securities if needed.
• Start work early, identify the stages that could inject risk into your workflow: market, credit, liquidity, operations risk.
• Involve those areas as early as possible.  Make decisions that work for the value chain as a whole
• Test new infrastructure to find weaknesses where trade flow mistakes may happen.
  • i.e., Erroneous transfers of cash or securities collateral.
• Determine which jurisdictions your firm is captured under for posting and receiving margin and what collateral is acceptable when receiving and posting margin.  Remember you may need to comply with multiple jurisdictions.
•  Review operational processes when setting up tri-party or third-party custodian.
• Ensure your firm has the capacity to manage the regulatory requirements.  

Portfolio Manager

Portfolio Managers & Traders will be involved because securities in your portfolios are going to be posted as Initial Margin (IM).  The posting and receipt of eligible collateral will be a significant consideration.

TASKS & TIPS                                                                                                                                                                                                             

• Margin calls: in the U.S., initial margin is due on T+1; In Europe IM is due on T+3
• Eligibility Requirements: what assets are eligible for posting as initial margin?
• Collateral Selection: which assets should you post? What factors are considered?
• Collateral Transformation: when should available assets be used to generate eligible collateral?
  • N.B.: If you have a collateral management desk, you’ll want to make sure you’re being financed at the lowest cost possible. 
• Familiarize yourself with the type of assets that can be posted as IM
• Securing a view of the portfolio of eligible collateral – or transformable – will put you in a better position to efficiently and optimally post margin.  Tools: i.e., orchestrator
• Familiarize yourself with Collateral Transformation.
  • This is an opportunity to explore how you can minimize any drag on the performance of your position. 

IT Manager

Your role includes building the tools from which the whole collateral process can run.

TASKS & TIPS

• Begin groundwork for connectivity to custodians, margin hubs, and portfolio reconciliation services
• Consider processing margin calls via electronic processes, not email.
• Make sure your process for collateral movements can accommodate growth.
• Develop a tech solution that ensures your entity can only accept regulatory eligible collateral from counterparties.
• Counterparty Schedule: see example attached
• Margin Calls: verify accuracy via connectivity with internal systems calculating same
• Post Settlement Obligations: Repricing, optimizing & transforming repriced collateral.

Depending on your staffing, resources, etc. consider partnering with a Third-Party collateral manager.  They can provide many of the necessary electronic solutions and integrate them within your front, middle and back-office systems. 

Summary & Conclusion

• 43 entities came into scope in phases 1-4. 
  • Entities with more than $1.5 trillion in AANA during the observation period. 
• Phase 5 estimates 200 new entities with greater than $50 billion AANA
• Phase 6 estimates 500 new entities with more than $8 billion AANA.  
• Entities with less than $8 billion in AANA aren’t likely to breach the minimum threshold of $50 million in Initial Margin (MTA).
• The challenges are many, but there are reasonable ways to lighten this load.  Click here to see the roadmap from Post-Observation to Initial Margin.  The map details each job function and which functions are involved at each step.

 

Roadmap for Phase Five Initial Margin for uncleared Derivatives

Click to Enlarge Roadmap