Catching the next wave of OTC derivative margining
The initial launch of the new regime for margin requirements for non-cleared derivatives passed on 1 September. This first wave affected those firms with the largest presence in the market for both initial and variation margins under the new regulations.
Perhaps the most important lesson that has been learnt is that the onboarding process takes more time and is more cumbersome than many thought it would be. However, deadlines do focus attention, and so while it was initially thought that some firms might miss the deadline, in the end banks report that it was all achieved on time. “There were some scary moments with lots of late documentation right up to the September 1 deadline,” says Geoff Robinson, Global Head of Industry Initiatives, Change & Strategy at HSBC.
Others agree that the process of initial onboarding was difficult, but that there is now an opportunity to improve it in the next waves. “All the firms met the initial deadline,” says Pierre Lebel, Managing Director, Head of Collateral Advisory at Societe Generale. “Now we have more time to make sure the process that had been a bit arts and crafts can become more industrial.”
The process of setting up new margining for OTC derivatives not only produces a lot of documentation; it also produces a lot of data. Managing the production, retention, utilization and reconciliation of this data is a vital aspect of the transition, especially for the end clients. “It is extremely important for us to be as close to the data as possible and to keep our hands on it,” says Peter Battley, Associate Director, Post Trade Change/Regulation at Fidelity International. “In particular, portfolio reconciliation is hugely important to get a successful collateral workflow underway.”
Meeting the data requirements is a challenge for the banks and their clients. But it is also a large opportunity for the whole industry. “Really understanding the new data flows emerging from regulation is a big opportunity for the industry; it will be transformational,” says Robinson.
Moving to a new margining regime takes time. Buyside clients need to understand quite how long the process will take. Battley at Fidelity says that his firm has been working towards this for more than 18 months. But other firms are perhaps not aware of how long it will all take. “Some smaller funds are not prepared for this at all,” says Lebel at SG. “The best are ill-prepared and the worst are not prepared at all.”
Lebel believes that the process of defragmenting current working practices and then centralizing the collateral management will take two to three years, if clients are looking to do everything in house. If they decide to outsource the process, this will still take a year.
The best time to start preparing for anything is twenty years ago: the second best is today. A key message from market participants is that preparation for this transition is key for it to be successful. “People need to prepare for this as soon as possible,” says Mark Jennis, Executive Chairman of DTCC-Euroclear GlobalCollateral. “Tactical responses are not enough. People really do need to think strategically about this.” The industry is working hard to help firms prepare for these changes.
In particular, ISDA is setting up standardized formats that firms will be able to tap into. “It is going to be a huge challenge for the industry to get ready for the next deadline of March 1,” says Roger Cogan, Head of European Public Policy at ISDA. “The role of ISDA will be to help people prepare for compliance through education – for example via webinars - and by timely release of legal documentation and operational solutions for exchange of IM and VM.”
Cogan also drew attention to a recent clarification by the European Commission (EC) to Members of the European Parliament (MEPs) with regard to the time available for counterparties outside the scope of IM to transfer VM. The EC had deliberately used the word ‘provision’ in article 12 of the final RTS, explaining to MEPs (in response to questions they asked) that this means that a counterparty will be in compliance if it has made instructions for transfer of collateral within a business day (as opposed to having to ensure that their counterparty has received the VM within a business day). This is a vital change.
While the past is prologue to the present, firms will face additional hurdles that firms involved in the first waves are just beginning to address. Perhaps the most important is that the industry will need to find ways of aligning what they are doing according to different regimes in the US and Europe.
There are also differences emerging between what is required for IM and VM regimes. According to Robinson at HSBC, VM “seems to be higher touch at the documentation level and there are extra layers of complexity.” VM could also carry difficulties for smaller funds. Lebel says that VM “could force smaller funds to convert collateral to cash, and they won’t like that.”
The benefits that are accruing to the market from the transition to a margining regime for OTC derivatives are plain. The market will be more resilient and risks less concentrated. The European and US authorities are still working through issues that have been raised by the first wave of transition, and market participants are moving into a new regime in which some issues are still to be addressed.
Yet the bigger picture is that with preparation, documentation, data and time, the subsequent waves will be a success. “The next phase will have challenges,” says Robinson. “But the industry is going through an immense amount of change all around the world.”