Regulators might have thought that setting specific rules for margining uncleared swap transactions would make life easier for financial firms because they will won’t have to negotiate over how, or even whether to collateralize their deals.
They couldn’t have been more wrong. So said panelists and attendees at the International Swaps and Derivatives Association’s recent North America annual conference in New York focusing on collateral management for uncleared swaps. The missteps in meeting the September 1 deadline to post initial margin for uncleared swap deals under US, Canadian and Japanese rules offered a glimpse of the hard work involved.
The challenges include how to quickly change existing contracts or create new agreements, how to determine which country’s rules apply for uncleared swap trades entered into by US and foreign counterparties, and how to make the post-trade process work seamlessly. A new ISDA whitepaper released at the recent event entitled “Future of Derivatives Processing and Market Infrastructure” recommends that firms work together to develop standardized data contracts, content, identifiers and post-trade procedures. Too often faxes and emails are being used to manage collateral requirements, ISDA warns.
Swaps — contracts in which two parties agree to exchange financial instruments — are used by financial firms to hedge risk or to make bets in areas such as fuel prices or interest rates. Blaming the use of over-the-counter financial instruments for the financial crisis, regulators on both sides of the Atlantic are coming up with new similar rules for how firms should apply initial and variation margin for uncleared swaps — that is, the estimated 30 percent of swap trades are “bilateral,” not processed through a clearinghouse serving as the middle man.
Handling bilateral deals will now be similar, if not more difficult, than handling cleared transactions because of the need for counterparties to not only post and collect collateral, but also to reconcile margin calculations with each other. Initial margin is intended to buffer against a potential counterparty default while variation margin reflects the change in the value of the swaps contract in any given day.
The world’s largest 20 banks managed to pass the first hurdle of margining uncleared swaps on September 1 when they had to post initial margin. However, there were plenty of teething pains. “We had our nose to the grindstone until the last minute,” says Eric Litvack, ISDA’s chairman and managing director of global banking and investor solutions for Societe Generale in Paris. At the eleventh hour, the Commodity Futures Trading Commission was forced to postpone one provision of its rules requiring that financial firms set up collateral agreements with custodian banks for thirty days, because financial firms couldn’t meet the September 1 deadline. US regulations require custodians to hold collateral on behalf of fund manager clients.
Fund managers attending the ISDA-event also say that margin calls for some cross-border deals between US and foreign counterparties missed the US requirement for being completed on the same day or at the latest the next day they were required. Time-zone differences weren’t taken into account when preparing for the new margin rules. Small to mid-sized players in OTC derivatives will be phased into US initial margin rules by 2020, but all firms must post variation margin as of March 1, 2017.
Short-term operational and legal glitches aside, financial firms must deal with regulatory uncertainty. The European Securities and Markets Authority (ESMA) has delayed adopting any margin requirements until early 2017, which could spell an overlap with the US rules for variation margin. Australia, Singapore and India have yet to announce when their rules will apply. “There is still a lack of clarity about what the European regulations will be like, so firms will have a steep learning curve when they are published,” says Scott O’Malia, ISDA’s executive director.
Harmony Isn’t Harmonious
Regulators have indicated that their rules on initial and variation margin will be “harmonized”, but that doesn’t mean they will be identical. There might be differences in the types of swap transactions affected or exempted, the type of collateral that can be posted, how haircuts for margin are applied and how quickly margin calls must be met.
Deciding which country’s rules to apply is moot when the two counterparties are located in the same market. The decision becomes tricky when counterparties in different markets are involved. If the CFTC and ESMA decide that each other’s rules are equivalent, then financial firms in the US or Europe doing cross-border transactions can choose between either US or European regulations. If the CFTC and ESMA don’t agree on equivalence, then both the US and European rules would apply.
So far, the CFTC has decided that Japanese rules are “equivalent” to the US ones. Even so there are some differences which one CFTC Commissioner found so blatant that she dissented from her colleagues. For example, US rules mandate initial margin be used in deals between affiliates while Japanese rules do not. That means that US swap dealers would not be required to post initial margin with their Japanese affiliate, but they would be required to collect margin from the affiliate.
Whether or not rules are considered equivalent, attendees at the ISDA event tell FinOps Report, there will still be haggling over which ones to use. “The firm collecting margin will want the rules requiring the most margin and the one posting margin will want the least margin or the rules with the most inclusive use of assets for collateral or the one which doesn’t require any collateral because the contracts aren’t covered,” says one collateral management director at a US bank at the gathering.
Whose country’s rules will win out? Most likely the most stringent rules will dominate. “Can you imagine a firm telling its regulator I collected less margin, or no margin because I used another country’s rules,” says another collateral management director. “Fat chance that will happen. No sane compliance department will want to use equivalence as an excuse for collecting less margin than their own regulators require.”
So what does “equivalence” really mean to collateral management operations executives? “They have to code within their collateral calculation engines the margin rules from multiple jurisdictions and know which one or ones will apply under which circumstance,” says Nihal Patel, an attorney in the financial services group of Cadawalder, Wickersham & Taft in New York. “Doing so won’t be easy since the European and Asian rules have yet to be adopted. So far, only US, Canadian and Japanese rules, so substituted compliance determinations are largely yet to be made.”
Financial firms with multiple units trading OTC derivatives in multiple jurisdictions will face the toughest challenges. “They will need to know which rules apply for which products and when,” says Mita Jash, director of global collateral initiatives for Bank of America Merrill Lynch. “The answer will differ on the country and legal entity involved. Cross-border transactions will have the most problems because of jurisdictional and time zone differences so firms need to take that into account when preparing.”
Market players hope the European rules will be adopted before the US margin rules for variation margin take effect so they have sufficient time to adjust. As FinOps went to press, some media reports had surfaced that the European provisions could be in effect beginning in January 2017. “Variation margin is now the focus of attention because of the March 2017 deadline,” explains Geoff Maskell, European managing director for Exari, a Boston-headquartered contract management firm that automates the workflow process.”Although variation margin will likely be far easier to calculate than initial margin, financial firms could have thousands of counterparties to deal with. If they rely strictly on manual intervention, the process will be cumbersome and error-prone.”
The ISDA has devised a variation margin protocol that is intended to simplify altering counterparty contracts. However, the process of following the protocol may become just as protracted as a case-by-case bilateral negotiation. “Although it will help with compliance, the ISDA protocol still requires counterparties to exchange complex questionnaires and one mismatched choice will require drafting and submission of revised questionnaires,” says Jonathan Martin, managing partner for legal consultancy Derivatives Risk Solutions in London. “Regardless of whether firms adapt their contracts bilaterally or use ISDA’s variation margin, they will need to decide whether to amend existing contracts or put in place new documentation for future trades.” It will all boil down to understanding the order in which they want to handle their portfolio of counterparties, knowing the contractual provisions in place, evaluating the extent to which they are compliant with the new margin requirements and determining how the contracts must be changed.
Even most efficient automated workflow process won’t be enough. Exari has partnered with firms such as DRS to offer firms the legal support to manage the negotiation process once Exari’s platform has created initial drafts of new variation margin agreements. DRS can also develop rules to create “smart templates” to implement the Exari workflow process.
Of course, legal contracts aren’t worth the paper they are written on if they can’t be enforced. The good news is that the ISDA has also come up with a common methodology firms can use when calculating initial margin so there are far fewer discrepancies or disputes to resolve. Called SIMM, short for standard initial margin model, the methodology has been endorsed by the CFTC and US banking regulators, while European regulators say they won’t oppose it.
Still, using SIMM isn’t foolproof. There could be differences between counterparties using SIMM if they use different risk buckets and weightings. A new SIMM crowdfunding utility run by ICE Benchmark Administration will aggregate risk data from participants to allow them to implement SIMM consistently based on a consensus approach. ISDA has also created a separate governance committee to review SIMM and consider tweaking it to accommodate more OTC derivative classes or any change in market conditions.
“The initial version of SIMM doesn’t contain all the risk factors and a governance process is needed to determine whether we have to modify SIMM or not in the future,” says Oliver Frankel, principal of Bilateral Risk Management, a New York-based consultancy. “Modifying SIMM won’t be easy because it would need to be revalidated and backtested.” He suggests that changes would take place only if participants complained that there was a large discrepancy between their margin calculations using SIMM.
If ISDA’s new study is any indication of how well financial firms are handling uncleared swap contracts, they are in dire need of automation. “It is concerning that electronic messaging has not become the defacto standard for business communication in some areas of the derivatives market, particularly given the timing requirements for certain processes under new margining regulations.” says the white paper. ISDA’s event offered some opportunity for software vendors to promote their applications, which have incorporated SIMM. Lombard Risk says it offers a one-stop collateral calculation, margin call and collateral optimization package. AcadiaSoft, best known for automating margin calls, will either do the initial margin calculation itself or validate the calculation. CME will allow its members to compare the amount of collateral they will need to use when processing the same trade bilaterally or through its clearinghouse.
Given that managing uncleared swap transactions can be as operationally difficult, if not more so, as handling cleared transactions, will firms abandon bilateral deals altogether? Probably not. A recent study issued by the Office of Financial Research, a unit of the US Treasury, suggests that because the margin requirements for cleared transactions are so much higher than the ones for bilateral, financial firms should think twice about processing their deals through clearinghouses.
However, there are plenty of academics and consultants who question the OFR’s methodology and rationale. “Regardless of the amount of collateral required, financial firms will likely want to process more trades through clearinghouses, because of the regulatory certainty involved,” says Sonia Goklani, chief executive of Cleartrack, a consultancy in South Brunswick, NJ specializing in derivatives. “Regulators might raise more questions when a trade is processed bilaterally.” What’s more, financial firms would need to manage their legal obligations more rigorously based on new and old agreements.
At least for now it appears that bilateral contracts are here to stay. Financial firms will just have to deal with all of the legal and operational quagmires involved. “We need to learn from the lessons of the first phase of initial margin implementation and have our legal agreements and operations in order before variation margin requirements take effect,” cautions Litvack. “I am worried about how much can be accomplished with so many moving parts.”