Euroclear Collateral Conference report

Over the next two years, Uncleared Margin Rules (UMR) will capture more and more buy-side firms, as the regulatory thresholds for applicability get lower.

When UMR was first brought in, regulators assumed that having five separate waves would equate to a gradual, phased process that would see it expand in fairly equal increments. But it has not worked out liked that.

During the UMR panel at the 2018 Euroclear Collateral Conference in Brussels, panellists agreed that the custody, clearing and settlement industry is now facing a situation where a huge proportion of the work that is needed to be done will have to be completed over the next two years. And much of the burden will fall on smaller buy-side firms who lack the resources to do it.

Challenging scope

The scope of what the industry is looking at can be seen in data prepared by the International Swaps and Derivatives Association (ISDA). During waves 1-3 of UMR, only some 34 global asset managers come under the scope of UMR. But waves 4 and 5 will see that expand to 1,200 firms, who between them will have some 9,500 counterparty relationships, each of which requires new sets of documentation.

During the UMR panel discussion, representatives from the custodian segment expressed concern that the scale of the challenge has yet to dawn on a lot of the buy side, especially in Europe.

One only has to look at the struggles experienced by firms in 2017 when they had to implement the then new variation margin rules to understand the enormity of the challenge facing firms in waves 4 & 5. The legal aspect of UMR will be several times more complex and generate several times more administrative workload – and not just for back-office staff.

Rules of engagement

So what precisely do asset managers need to do? According to several of the margin experts on the UMR panel at the Euroclear conference, the list of actions is extensive.

Firms need to set up segregated accounts both for what they are collecting and for what they are posting. They need new Credit Support Annexes (CSAs) covering Initial Margin (IM), in which firms need to agree how they will calculate IM, the eligible collateral, the haircuts, how Non-Transferrable Assets (NTAs) will be broken down, how thresholds will be split, and how they are going to separate regulatory and non-regulatory IM.

Furthermore, not all transactions will be subject to the rules. There is concern from within the industry that identifying in-scope transactions will be much more challenging than people anticipate. For instance, equity options are out of scope in the US and Singapore, but in scope in Japan, Canada, Australia and Brazil, while there are temporary exclusions on them in the EU, Hong Kong and Korea. The regional differences will certainly only add to what is already shaping up to be a very complex implementation.

Lessons learned

While conceptually the rules are fairly simple, the two areas that will take the longest will be the legal necessity to negotiate and agree hundreds of new documents, and then the operational and IT changes to automate what is agreed. The clear examples of what happened in waves 1, 2 and 3 show that it is these practicalities of implementation that take the most time.

One of the UMR panellists referred to phase 1, back in September 2016, ‘as a fire drill’ for the upcoming waves. Indeed, all panellists agreed that, at a basic level, the exchange of margin is a fairly benign business and it happens all the time. But the 2016 Standard Initial Margin Model (SIMM) requirements asked for a lot more than just a standard variation margin exchange.

Waves 1 to 3 showed that firms needed new documentation, new customer selection, fresh understanding of collateral eligibility risk and collateral optimisation. The implementation of these waves also included a huge amount of tech and infrastructure changes for the IT and operational teams within firms. Firms needed to implement changes that allowed them to differentiate SIMM from non-SIMM requirements as well as how this information was fed into systems subsequently reported.

For the majority of the UMR panellists at the Euroclear conference, the work did not stop once the wave of implementation passed. Adhering to, reporting and managing the process also proved to be intense. With firms suddenly exchanging much more margin, many more disputes have arisen, which had to be monitored and managed through operations.

Managing the impacts

The impact of waves 4 and 5 will not just be limited to the individual firms. Once these UMR are in place and the market follows the new rules, there will be a collateral drag on performance and an overall loss of liquidity that will impact the wider global asset management industry.

Many asset managers are already looking to consolidate due to increasing costs and weak performance: waves 4 and 5 of UMR will likely accelerate that trend. One of the investment bankers on the panel made reference to the fact that the industry is already posting over USD 100 billion of uncleared margin, which is a huge cost to the industry in terms of loss of liquidity. And much of this is posted in the form of segregated assets that cannot be rehypothecated, which in turn is a huge drag for the whole business.

Staying afloat, and on course

While this all sounds scary, solutions are at hand.

Global custodian banks are taking the lead in terms of getting their buy-side clients ready for what is to come. Moreover, technical solutions from market infrastructure players such as Euroclear and DTCC-Euroclear Global Collateral can help clients get far along the path of compliance with the new rules.

Finally, according to industry association representatives on the UMR panel, there is a chance that regulators might amend UMR.

Global regulators have been presented with data showing the sheer size of waves 4 and 5 and they have taken heed. They may still give the market some leeway, either by increasing the threshold of eligibility, or extending the timeline for implementation.

But even with that, UMR is not going away, and with it comes a whole new operating model for the global asset management industry.

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