As market participants are all too aware, following the financial crisis in 2008-2009, G20 agreed to a regulatory reform agenda covering the OTC derivatives market and market participants, including proposals for margin requirements for non-centrally cleared derivatives. The recommendations were finalised in the BCBS-IOSCO’s Final Framework for Non-Centrally Cleared Derivatives, which established the international standards of margin requirements that were to be introduced in phases.
For the largest market participants, the Uncleared Margin Rules (UMR) were first phased in on 1 September 2016, which, apart from custodian-related hiccups limiting first day’s trade to 50%, were relatively uneventful. Variation Margin (VM) requirements were then introduced in March 2017, resulting in a market “big bang” where less than half of affected market participants were compliant by the implementation date. With phase 3 Initial Margin (IM) requirements coming into force in September 2018, the transition is expected to follow suit from previous waves of IM deadlines with minimal issues. However ISDA anticipates phases 4 and 5 to cause major disruptions to the market due to the scale of participants coming into scope.
As implementation deadlines for the final phases of the framework loom closer, ISDA warns newly in-scope counterparties (NISCs) of the not so distant challenges that can be expected from the upcoming IM requirements. The large number of counterparties coming into scope during 2019/2020 will generate an “untenable rush” on resources for both participants and service providers, resulting in extensive operational and technological builds. In earlier IM phases, larger institutions were able to engage with the implementation timeline in a way that may be unrealistic for NISCs. Final phase IM requirements are predicted to unleash unprecedented implementation challenges that threaten to disrupt the functioning of the derivatives market.
Margin requirements for non-centrally cleared derivatives were first introduced in September 2016. In 2016, the first to be impacted by the IM requirements were firms with an average notional amount of non-centrally cleared derivatives of USD 3 trillion. By 2019, firms with USD 750 billion in derivatives will be brought into scope under the rules, with the threshold dropping drastically in 2020 to USD 8 billion.
Initial and Variation Margin Phase-In Schedule for Major Jurisdictions
|Phase I (IM/VM)
|Phase II (VM)⁸
|Phase II (IM)
|Phase III (IM)
|Phase IV (IM)
|Phase V (IM)
|US||USD 3 t||USD 8 b||USD 2.25 t||USD 1.5 t||USD 0.75 t||USD 8 b|
|EU||EUR 3 t||EUR 8 b||EUR 2.25 t||EUR 1.5 t||EUR 0.75 t||EUR 8 b|
|Japan||JPY 420 t||JPY 1.1 t||JPY 315 t||JPY 210 t||JPY 105 t||JPY 1.1 t|
|Canada||CAD 5 t||CAD 12 b||CAD 3.75 t||CAD 2.5 t||CAD 1.25 t||CAD 12 b|
|Switzerland||CHF 3 t||CHF 8 b||CHF 2.25 t||CHF 1.5 t||CHF 0.75 t||CHF 8 b|
|Singapore||SGD 4.8 t||SGD 13 b||SGD 3.6 t||SGD 2.4 t||SGD 1.2 t||SGD 13 b|
ISDA highlights how dealers can expect to face an estimate of 1,000 NISCs and 9,400 new relationships in the final phase in 2020. This will be demanding on dealers as there will be a surge of account set-ups and contractual documents required by each new relationship. With each counterparty requiring a custodian account, dealers can anticipate 18,800 segregated IM accounts that will need to be KYC’d, set up and tested.
It is suggested that the new IM regulations will require a change in market practice that NISCs are unfamiliar with and that current operational systems are incapable of managing. ISDA maintains that final phase IM requirements propose a “broad departure from historical practice”, anticipating full-spectrum disruption ranging from issues with documentation, segregation and custodial agreements, funding, operations, IM calculation concepts, set-up and collateral optimisation. The implementation of substantial front-to-back alignment will be essential for NISCs to achieve compliance.
Market participants that are not directly subject to UMR are also advised to engage in preparation to avoid disruption to their trading. Unlike the EU and Japan, where dealers and their counterparties are both directly subject to UMR requirements, in the US only dealers are directly subject. Both counterparties to a transaction need to have the necessary documentation and custodial arrangements in place regardless of whether one or both parties are subject to UMR requirements. Delay or failure to prepare for the imminent IM requirements could result in trading relationships being unable to continue, having a detrimental effect on the liquidity and operation of the derivatives market.
Challenges for Newly In-Scope Counterparties
ISDA anticipates that NISCs will struggle with implementation and fear that the stampede of NISCs trying to immediately comply with the regulations could potentially “congest or overwhelm industry resources”. Outright ignorance of, or less experience and familiarity with the critical rule requirements will be challenging for NISCs. The comprehensive planning that is required to comply with final phase requirements will demand resources that may be less readily available to NISCs than the large financial institutions that have come into scope to date. Implementation challenges will be exacerbated by the radically condensed timeframe ‘per capita’ encountered by NISCs. Furthermore, NISCs that trade globally will face additional UMR requirements in multiple jurisdictions.
Entity Assessment and Disclosure
Market participants may struggle to self-identify their aggregate average notional amounts (AANAs) and communicate them to counterparties quickly. Self-identification of AANAs will be needed by market participants to distinguish whether they fall within scope of IM requirements. Failure to do so in a timely manner could lead to substantial market uncertainty and further time to compliance pressure. Individual dealers are unable to unilaterally determine a party’s AANA, as it is based on the party’s market wide trading activity, and therefore it would be impossible to determine whether a given counterparty is in scope.
Having confirmed that they are trading in scope products, participants will then need to identify which of their entities may come into scope during the remaining phases of IM implementation. The typical observation window for AANAs is between March and May after which a definitive determination can be made for a September implementation date. It is crucial that market participants conduct estimates before the observation window in order to have enough time to prepare.
Once NISCs have self-identified, they will need to disclose their predicted status to trading counterparties. ISDA advises that early disclosure to counterparties is of the utmost importance, and warns that the significant number of counterparty relationships affected requires self-disclosure to be provided at least 24 months before the IM implementation deadline in September 2020. Failure to do so could result in an inability to trade OTC and consequent further disruptions to and lack of liquidity in the derivatives market.
Credit Support Annexes
All counterparties, under the new margin rules, must adapt existing or negotiate new Credit Support Annexes/Deeds (CSA/Ds) and Collateral Transfer Agreements (CTAs) to incorporate new IM rules and practices, in reality the complexity of IM documentation effectively mandates ab initio negotiation rather than amendment. The scale of CSAs to be negotiated is “immense” and will undoubtedly cause extreme documentation challenges for NISCs.
The challenge of IM negotiations should not be underestimated, requiring input from multiple stakeholders in the extensive negotiation including but not limited to: eligible collateral; operational requirements (e.g. transfer timings); SIMM versus grid; jurisdictional nexus per counterparty; and a full range of custodian documentation and agreements.
Phase 4 Document Structure
The challenges that are expected in the lead up to Phase 4 have prompted ISDA working groups to begin to prepare the following in order to streamline compliance by the deadline:
- Refined Phase 1 CSA language and lay out
- “Next Generation” Phase 4/5 documentation and architecture
- New Umbrella language
- Standardised custodian documentation
- Development of negotiation platform software
The most significant change is the development of “Next Generation” documentation. In anticipation of vastly increased volume and the advent of multiple custodians, the proposal seeks to create a documentation architecture which is agnostic as to choice of custodian and governing law.
Two industry platforms are currently working toward launching services to streamline and accelerate the negotiation process for IM documentation.
Two initiatives are:
- MarginXchange, to be delivered by a partnership between Allen & Overy, IHS Markit and SmartDX
- ISDA Create, to be delivered by a partnership between ISDA and LinkLaters
These services are still in development so full details on how they work and commercial terms are not yet public. It is assumed that each of them will provide methods of communication between market participants and their counterparties, offer templates and support for the necessary legal documentation for IM, and aim to speed up the two-way negotiations to achieve executed margin agreements from those platforms.
Swap dealers are providing considerable resources to the onboarding of NISCs. Despite this, NISCs should begin negotiating terms as soon as possible to avoid the possibility of backlogs. ISDA stresses that NISCs may underestimate the significant efforts that will be required for compliance. During the first phases of UMR implementation, large dealers were able to facilitate standardised templates for CSAs, however given the low AANA thresholds applicable in the final phases, and the diversity of NISCs, negotiations will be far more complex. The negotiation timeline is tight, unexpected delays are only to be expected, and NISCs could ultimately run out of time.
Considerable challenges are fast approaching as market participants attempt to execute extensive volumes of documentation and build connectivity with custodians. In-scope firms are required to segregate their regulatory IM at a third-party custodian under UMR. Previous UMR phases have revealed that the negotiation and execution of custodial agreements and collateral schedules have been extremely time-consuming. For each new custodian relationship, NISCs must satisfy anti-money laundering (AML) and know-your-customer (KYC) requirements, processes that can take months, both in addition to requirements relating to third-party cybersecurity verification. NISCs must also ensure that infrastructure pipelines that communicate collateral exchange and status with custodians are built and tested months in advance.
Account Control Agreements and Eligible Collateral Schedules
Custodian account control agreements (ACAs) and pledge agreements will need to be negotiated between NISCs and custodians. Each custodian relationship will require segregated accounts for the posting and collection of collateral to be set up for each relationship that will post and collect IM. Both accounts will require a bilateral Custody Agreement (CA) and a tri-party ACA and Eligible Collateral Schedule (ECS) , all governed by a single CSA.
For previous IM phase-in dates, execution of the ACA has generally been required by custodians by the June prior to the September implementation deadline. The deadline aimed to ensure enough time for accounts to be set up and tested, however these time restrictions have proved difficult for previous entities and are even more likely to cause further issues for NISCs. ISDA encourages NISCs to fully negotiate custodian agreements before the first quarter of the respective phase-in year. In order to meet these deadlines, it is essential for NISCs to conduct early AANA calculations to ascertain their in-scope population. Establishing this before the AANA period begins will allow NISCs more time to complete negotiations with custodians, although this will strain an already restricted timeframe.
Once arrangements with custodians are finalised, NISCs must then agree to ECSs. Previous phases have indicated that these too are extremely time consuming.
In Summary – Start Now
The OTC derivatives market expects to face considerable challenges during the upcoming IM requirements in 2019 and 2020. ISDA highlights that these challenges are due to:
- the large number of counterparties coming into scope,
- the extensive technological build and organisational requirements, and
- the expected rush of demand on market resources during a relatively condensed period.
In order to comply by the implementation deadline, NISCs must immediately engage in dialogue and preparation. Phase 1 provided important insight into the challenges that can be expected, although NISCs should anticipate more gruelling implementation circumstances due to the sheer magnitude of counterparties that will come into scope in final phases. The preparation burden on NISCs is immense, it took Phase 1 firms two to three years to prepare their infrastructure, processes and documentation. This will be significantly harder for NISCs due to the lack of available resources and the extremely tight timeframe. Many firms will rely on external third parties for expertise and short-term resourcing, however reliable professional help will be in high demand and may be occupied or simply unavailable. Aside from a small number of law firms and consultancies (including DRS), IM experience has to date been confined to in-house banking and legal teams.
It is crucial for NISCs to formulate their strategies and plans immediately. Firstly, NISCs will need to engage in self-assessment in order to disclose to counterparties which of their entities will be in scope. Following this, NISCs will need to adapt existing or negotiate and execute new credit support annexes, custodial arrangements, eligible collateral schedules and account control agreements with counterparties and custodians alike.
ISDA warns the significant risks for NISCs that are unable to achieve compliance in a timely manner. NISCs may be unable to access their previous OTC trading venues and require alternative ways to less precisely hedge their exposures. Alternatives which, in the cleared product market, may not be feasible. This could result in NISCs being blocked from the most appropriate hedging products to suit their needs if they do not act now.
There has been mention of market participants attempting to increase the phase 5 threshold to a minimum of USD 50 billion through lobbying, effectively knocking out half of the potential entities coming into scope. However, this would need Level 1 validation under EMIR and to go through the trilogue process before any amendments could be made. It is unlikely that these changes will happen before the phase-in deadlines. Even if lobbying efforts are successful, although the number of potential NISCs may be halved, the IM challenge across the market will remain immense.
In conclusion, it is imperative that market participants act immediately to prepare for implementation deadlines. As previously stated, the significant number of counterparties coming into scope will put pressure on market resources and likely run into serious technological and operational road blocks. ISDA warns that many NISCs are unaware of the “crowded implementation environment ahead of them” and urge NISCs to begin initial tasks like data cleansing and entity scoping in order to achieve timely compliance. It is possible that NISCs will be unable to achieve compliance by their relevant phase-in date even with the application of appropriate resources which could result in market disruptions, limited liquidity and restricted ability to manage risks.