Post the financial crisis of 2007-2008, the G20 instigated a regulatory reform compiling of a list of international standards to cover OTC derivatives markets and other market participants. In 2013, the Basel Committee for Banking Supervision (BCBS) along with the International Organisation of Securities Commissions (IOSCO) produced a framework for margin requirements for non-centrally cleared derivatives. From this, global regulators implemented the BCBS-IOSCO framework into a set of rules titled ‘Uncleared Margin Rules’ or UMR, that would be phased in over a set period, and would require the exchange of initial margin (IM). As per the European Market Infrastructure Regulation (EMIR), implementation of variation margin (VM) requirements occurred in 2017, whereas IM requirements are currently being phased in, up until 1 September 2021.
What is IM?
Initial margin is collateral collected by a counterparty and posted on a two-way basis (each party posts and receives at the same time) to minimize current and potential risk exposure. Any margin collected and posted under UMR, is referred to as ‘regulatory margin’.
For firms to determine if they are in scope of the UMR, they must first calculate their “Average Aggregate Notional Amount” or AANA. To calculate your firms AANA is to sum the total outstanding amount of non-cleared derivative positions during the prescribed observation period on a gross notional basis. All instruments are to be considered when calculating a firms AANA. Once a firm determines if they are in scope, they should begin the process of disclosing to their counterparty group(s). Firms that may be subject to the requirements include asset managers, banks, corporates, hedge funds and pension funds.
The most common methodology firms are utilising for calculation of IM, is the Standard Initial Margin Model (SIMM) however, this is not an official market standard.
In 2016-2018, during the first three phases of implementation, firms initially with an AANA of over €1.5 trillion in derivatives balances, went live under UMR; this impacted a relatively small number of market participants. Industry leaders expect there will be a significant increase in the number of firms captured during phases four, five and six, with an estimated amount of over 1,000 additional firms. Having to post IM will be new to most firms, particularly those on the buyside. Introduction of the final phases will require firms to not only implement the regulation themselves, but also begin to exchange IM with all firms from previous phases. Implementation will occur in groups of value of non-centrally cleared derivatives as follows:
Firms with an AANA of less than €8 billion will fall out of scope of the UMR, as well as jurisdictionally exempted firms. Additionally, margin rules in the EU do not apply where one party is a non-financial counterparty (NFC), or to financial counterparties that are subject to clearing rules under EMIR.
Although UMR is directed at the derivatives market, it has a significant impact to the use of collateral for securities lending participants. Firms impacted the most will be predominantly buyside entities. Under UMR, unlike other requirements such as VM, IM is a two-way exchange with liquidity and funding implications, hence buyside firms will now need access to collateral that is eligible for initial margin, and also check whether their counterpart is in agreement on the type of collateral. Historically, VM has been posted as cash, whereas regulatory IM is generally non-cash collateral.
There are standard eligibility criteria for regulatory IM, and this can pose a problem to several firms; many buy-side entities will not have a treasury function for instance, and therefore unable to hold cash as a collateral type. In this case, buyside firms will have to utilise securities lending programmes in order to substitute and enhance their collateral.
UMR will inevitably cause a high demand for High Quality Liquid Assets (HQLA) for margin calls, as the regulator has specified the quality of the collateral to be used, and advised that it must be segregated and not used for re-hypothecation. This removes liquidity from the market however, and will only increase as the remaining phases of UMR approach.
In addition to the above, UMR will have a huge strain on resources for collateral teams on both the sell side and buyside, due to the need for more frequent margin calls, managing IM calculation discrepancies and break resolution requirements.
Other regulatory reforms such as (SFTR) Securities Financing Transactions Regulation (SFTR) and Central Securities Depository Regulation (CSDR), will affect the settlement and reporting of initial margin exchange which will add additional pressure to firms.
September 2016i Phase 1
Entities with an AANA > €3 Trillion
September 2017i Phase 2
Entities with an AANA > €2.25 Trillion
September 2018i Phase 3
Entities with an AANA > €1.5 Trillion
September 2019i Phase 4
Entities with an AANA > €750 Billion
September 2021i Phase 5
Entities with an AANA > €50 Billion
September 2022i Phase 6
Entities with an AANA > €8 Billion