March 5th, 2019 by Nick Railton-Edwards
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Banks have spent the last four years gamely preparing for and complying with IM regulations. Phases 1-3 have been challenging, the current phase 4 promises more of the same. The market has long been aware that phases 1-4 are mere kittens to the phase 5 (probably angry) tiger. Useful initiatives- negotiation platforms, custodian portals, standardised collateral schedules, NextGen documentation- are all on their way, none of them adequately solve the question “Where are we going to get enough lawyers?”

As previewed in last week’s press release, BCBS\IOSCO have today released the following statement:

Significant progress has been made to implement the framework for margin requirements for non-centrally-cleared derivatives. Based on monitoring of the implementation of the framework across products, jurisdictions and market participants, the Basel Committee on Banking Supervision (BCBS) and the International Organization of Securities Commissions (IOSCO) today provide the following guidance to support timely and smooth implementation of the framework and clarify its requirements.

  • The Basel Committee and IOSCO realise that market participants may need to amend derivatives contracts in response to interest rate benchmark reforms. Amendments to legacy derivative contracts pursued solely for the purpose of addressing interest rate benchmark reforms do not require the application of the margin requirements for the purposes of the BCBS/IOSCO framework, although the position may be different under relevant implementing laws.
  • In the remaining phases of the framework’s implementation in 2019 and 2020, initial margin requirements will apply to a large number of entities for the first time, potentially involving documentation, custodial and operational arrangements. The Basel Committee and IOSCO note that the framework does not specify documentation, custodial or operational requirements if the bilateral initial margin amount does not exceed the framework’s €50 million initial margin threshold. It is expected, however, that covered entities will act diligently when their exposures approach the threshold to ensure that the relevant arrangements needed are in place if the threshold is exceeded.

The first bullet point regarding amendments for IBOR replacement is a useful and timely clarification. There has been speculation and concern that rate replacements in legacy contracts would constitute a change to primary economic terms, thereby bringing these transactions into the margin regime. Noting the caveat re. local laws, this is at least one Libor question that can be laid to rest.

The second statement combines simple fact with magnificently vague hints. The WGMR does not contain detail as to when documentation should be executed and custody accounts set up. There is an inference that regulators have some latitude to adjust their pre-threshold breach obligations. It seems clear that the threshold remains firm- relevant arrangements will need to be in place before the threshold is breached. It remains to be seen if this “clarification” will result in co-ordinated adjustment to local margin rules. On the assumption that it will, how will it affect the phase 5 newly in scope population and how should market participants adjust?

ISDA estimate that between 70-80% of phase 5 relationships will not exceed the 50 mln. threshold two years into the 1 September 2020 obligation. On the relatively safe assumption that the recommendation will be globally adopted, it would seem that the IM phase 5 population will be eviscerated, the cliff edge of over 10 times population increase decreases to a gentler gradient of approximately times 3.  While this would still represent a large increase on total population to date, it would be more of a baby boom than a demographic apocalypse.

Phew! Crisis averted….Probably not.

The detail-lurking devil is in the operational practicality. EMIR (and other regulations) allow an FC to exempt a counterparty from exchanging IM until a EUR 50mln. group level exposure is breached. Capital is held against such exposure pending breach.  In the absence of a negotiated and executed CSA it is difficult to see how the FC can begin to calculate its counterparty exposure, the imminence of its breach or the amount of capital to be applied. It may be possible to exchange a sort of “SDL on steroids” containing enough information to make calculation possible. However, without negotiated agreement on commercial terms, this would lack legal definition and validity. How many banks have the ability to calculate IM on a possibly vast number of “dummy” portfolios? The answer is- very few- likely confined to those who initially developed the SIMM and undertook subsequent capacity expansion since. Rather than build a “shadow” system to monitor when a CSA should be put in place; it surely makes more sense to execute the CSA and use existing systems to monitor the threshold breach. Of course, there are third party vendors who would be happy to do the job for you, but they too will need definition on counterparty commercial terms- onboarding and validating their systems is likely to prove as onerous as extending your own.

The recommendation is more interesting in respect to custodian accounts, the cost of setup and maintenance is not insignificant and they have continued to be the bottleneck in the IM process. The latitude for document negotiation varies by custodian, but account onboarding is lengthy for all. If a bank puts a CSA in place, it saves money by virtue of reducing investment in monitoring systems, a custodian only gets paid for the setup effort when the account is funded. This is a question to be resolved by the individual Regulators’ guidelines as to timing pre and post breach.

Industry groups threw many possible mitigants against the phase 5 regulatory wall in the hope that one or more may stick. Today’s BCBS\IOSCO recommendation consigns other solutions to the also ran category. The choice was likely made on legally expedient grounds, simply raising the in-scope threshold to 50 or 100bln variously required changes to primary legislation, inhibiting the prospect for timely global adoption.

IM documentation is complex and challenging, but it is far from the most difficult and expensive part of IM compliance. The recommendation has the wrong focus, documentation comes at the end of a long line of collateral and operational processes. The IM monitoring effort to see if documentation work needs to be done will engage a large proportion of the work that it seeks to avoid. Somewhat torturously, the job of assessing whether documentation is needed is much more easily performed with documentation in place. ISDA estimate that half of the 70-80% now perhaps not immediately in-scope entities will never reach more than EUR 10mln or equivalent in exposure. Banks may be able to justify internally and externally that this subset should be subject to less frequent monitoring and should be exempt from prudential documentation and custody account requirements. Assuming a conservative pre-recommendation phase 5 population of 1,100, 75% are taken out of formal deadline compliance by the regulation amendment, leaving 825, half of which are removed by virtue of never being likely to obliged, leaving 413. Adding the 413 to the “have to comply” 275 rump leaves 688. This equates to a potential 38% “reduction” in phase 5 population. Note that the other 413 are estimated to cross the threshold within two years. In summary, the mitigation leaves 275 entities firmly in scope, potentially delays the need for 413 to comply while imposing an onerous monitoring obligation and raises a question over the remaining 413. These numbers are all at the low end of ISDA estimates, but all pre-AANA calculations are oracular at best.

Again, dependent on the detail of local implementation (if any), at least in terms of CSA documentation, the choice is upgrade systems or employ external vendors to see if you have to comply, or save money and gain certainty by complying in advance. Mitigation is typically defined as “the action of reducing the severity, seriousness, or painfulness of something”. The recommendation arguably reduces the severity by making the deadline diffuse for a large part of the population; it does not affect severity, failure to comply when necessary will still result in an inability to trade; rather than reducing the painfulness, it partially shifts the pain from overstretched lawyers to overtaxed operational and systems functions. Market participants facing phase 5 should keep their champagne on ice.

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