December 5th, 2018 by Nick Railton-Edwards
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Rising to the repapering challenges of IM Phases 4 and 5

 

Introduction

The deadline for compliance with Phase 4 and Phase 5 of the IM requirements is miles away, isn’t it?  Isn’t it…?

The truth is that, whether you like it or not, the clock is already ticking.  Whether anyone has told you or not, the countdown has already begun.

Why worry about it now?

The classic quality triangle tells us that there is always a choice to be made between time, cost and quality.  In other words, you can have something done quickly, done well or done cheaply, but you can’t have all three.  But that’s exactly what you want when it comes to IM repapering, isn’t it?  You want (need) the work done on time, to a high level of quality and in as cost-effective and cost-certain a fashion as possible.  Moreover, you want it done in a way that minimises the burden on your in-house team (because they already have enough other things on their plate).  Unfortunately, the compromises inherent within the quality triangle are going to become all too apparent through the process of IM repapering.  Why?  There are a number of reasons.

It’s big and complex

Firstly, from a documentation point of view, IM repapering is big and is orders of magnitude more complex than VM repapering.  With respect to size, the table below provides an estimate of the number of in-scope entities for each phase of IM:

 

There is an on-going advocacy effort to reduce the scope of Phase 5.  If successful, it is estimated that the number of in-scope entities would fall to approximately 100.  Unfortunately, you can’t rely on this being successful.  Even if it were, Phase 5 will still be roughly the same size as all other previous phases combined.

With respect to complexity, don’t even think about amending existing documentation to make it IM compliant.  Therein lies a world of pain and you will be swimming against the tide of the industry.    You need a new documentation suite which is designed to meet your IM needs.  Unfortunately, in contrast to VM ‘big bang’, where there was only one document to put in place, IM repapering will usually require the negotiation of 4 documents per counterparty pairing.  In addition to a collateral schedule (a document that details the type of collateral counterparties can post to each other) you will also have to negotiate:

An IM CSA/CSD (or a CTA and Security Agreement):

The DNA of an IM CSA is inherently more complex than that of a VM CSA.  IM CSAs calculate collateral requirements separately with respect to each “Regime” in accordance with a defined “Method” (usually, but not always, ISDA SIMM).  They are also much more complex in the way they define and handle ‘defaults’ by the provider of collateral, the holder of collateral, and the custodian – all of which can result in the liquidation (or return) of the collateral.

Alternatively, you may prefer to negotiate a Collateral Transfer Agreement (“CTA”) instead of a CSA/CSD.  The CTA essentially mirrors the operational mechanics of the CSA but does not include a security interest.  It requires the execution of separate Security Agreements (one for each party when acting in the capacity of a provider of security).

Account Control Agreements

Initial margin is typically held in a segregated account by a third party custodian.  This necessitates the execution of an Account Control Agreement – a document which details the circumstances in which the Custodian may release the collateral to the secured party (or return it to the provider).  Usually, two Account Control Agreements are required – one for each party when acting as the provider of collateral.

It’s more time-consuming

Secondly, IM repapering is going to require a longer lead-time.  In reality, the starting gun for VM ‘big bang’ compliance was fired in January 2017.  By the original deadline for VM compliance (1 March 2017) average CSA execution rates across the industry were reported to be 40.72% (a remarkable jump from the 8% of 22 February!) with only 10.45% of documents having been loaded into bank reference data systems deadline.  In other words, even if the reported figures are to be believed, the industry did not give itself anywhere near enough time.  Don’t assume that regulators will grant an extra six months – as was the case with VM.  In any event, six months might not be sufficient.  During Phases 4 and 5, we will experience a significant shift in levels of awareness and education, as well as incentives to actually get documentation signed.  Neither is ISDA going to provide a protocol to help us along the way.  As such, expect the negotiation process to take much longer than VM repapering.

The skills aren’t out there

Thirdly, the skills shortage is already evident.  The scarcity (and expense) involved in getting good derivatives documentation negotiators was evident throughout VM ‘big bang’.  The talent pool is even more scarce when it comes to IM – a process further complicated by the fact that many of these documents are literally brand new.  The basic law of supply and demand tells us that when something is scarce it is going to become more expensive.

So I need to do something…where should I start?

Nobody will know the full scale of Phases 4 or 5 until AANA numbers come out in March – May 2019.  However, you simply can’t wait that long.  If you suspect that you might be a Phase 4 or 5 entity, use your 2018 AANA numbers as a guide.  If you are a Phase 1 to 4 entity, start now and treat Phases 4 and 5 as one project.  Build a team and don’t make the mistake of letting it disband.  If you are a Phase 5 entity, start planning now.  The two basic questions you need to answer are “where will I get the resources I need?” and “how many people do I require?”

Where will I get the resources I need?

There are four basic options available to any firm which is subject to the IM requirements:

Use in-house resource

Is this a realistic option?  Can you really afford to take your eye off ‘business as usual’ workstreams?  Even if you could, would you have the necessary level of resource or experience to execute an IM repapering project properly?  Many firms have already answered these questions in the negative.

Access the temp market

There is a real scarcity of IM experience in the market.  The IM knowledge that does exist sits almost exclusively within Phase 1 and 2 banks.  Those banks are not only taking steps to retain their existing IM knowledge, but they are actively acquiring additional IM experience in anticipation of Phases 4 and 5.  This fact means that, if you can access the resource at all, the cost is likely to increase significantly as the Phase 4 and Phase 5 deadlines loom.  In all likelihood, you will end up with some (hopefully good) people, but you will almost certainly need to train them up.  They are likely to have no experience of IM or possibly even of working within a major financial institution.  Can you live with that?

Law firms

By design, law firms are set up to provide legal advice.  They are not set up to deliver large-scale documentation projects.  They also carry a relatively high-cost base – long-hand for saying that they are a relatively expensive option.  Remember, as large as they are, they too have relatively limited numbers of lawyers with significant IM experience – many of whom are already effectively retained by the Phase 1 and 2 banks.

Other vendors

For many, third-party document outsourcers will represent the only real option.  But take care in your choice of vendor.  Remember that they will not have a bottomless pit of IM resource either.  You are likely to get a tightly-controlled process, but will it be the one that you need at a price that makes sense?  VM ‘big bang’ taught us that we need to be flexible in our approach to large-scale repapering exercises.  A process which allows only a limited number of interactions with each counterparty or regards complexity as an exception to be handed back to in-house teams is unlikely to be of much assistance.

How many people do I require?

This is the $64,000 question.

The real answer is that nobody knows just yet.  Take any estimate with a large pinch of salt – even ours.  However, in trying to figure this out, it’s helpful to look at two inter-related questions – “How many negotiations can one person handle?” and “How long will a negotiation take?”

How many negotiations can one person handle?

Estimates vary.  We have collected a significant amount of hard data in relation to IM negotiations conducted on behalf of our existing clients.  This would tend to suggest that, with full focus and the right support, one negotiator can handle between 25 and 30 negotiations at one time.  How accurate is this number?  Only time will tell, but it is under constant review.

How long will a negotiation take?

Again, we have gathered a substantial amount of data on this aspect of IM negotiations across IM Phases 1 to 3.  This would tend to suggest that it is possible to get a single suite of IM documentation negotiated and executed within 4 months.

Admittedly, all of our current data relates to Phases 1-3.  Phases 4 and 5 will probably look quite different.  Education levels will be lower and, because of the new breed of documentation, the sell-side will be getting up the learning curve at exactly the same time as their clients.  This being the case, 4 months may turn out to be an underestimate.

On the flip-side, a number of factors may decrease the time required in order to negotiate IM documentation.  A proportion of any portfolio will comprise replications and umbrella agreements.  These will undoubtedly take less time to process than a standard document suite.  Beyond this, technology solutions are currently in development.  These will help with first draft production and the extraction of data from executed documents.  Time savings will result, but these solutions will not be a replacement for experience or basic IM subject matter knowledge (in fairness, they are not marketed as such by their developers).

So, based on these assumptions, how many people might you need?  Again, nobody really knows.  However, with one year to execute an IM project and one group entity’s contractual arrangements to repaper with a universe of 200 IM counterparties, you would need in the region of 200/25/3 ≈ 3 good and experienced negotiators to execute this volume of work.

But, of course, that number represents a best case scenario.  It could change dramatically.  What if you only had 6 months left in which to execute the project?  The number of people required would double.  What if you were negotiating on behalf of multiple group entities (and so were a number of your counterparties)?  What started out as a team of 3 negotiators could easily become 10 or more.

This estimate also assumes that all of your counterparties are as organised, motivated and well-resourced as you are (something which, given the absence of IM legal experts will almost certainly not be the case).  It assumes further that you have perfect data, a seamless on-boarding process and the ability to send out documentation without delay.  Experience would suggest that this almost certainly will not be the case either.  Add to this the fact that more custodians are going to be introduced into the mix for Phases 4 and 5.  Custodians were one of the main bottlenecks for Phases 1 and 2.  The introduction of more (and smaller) custodians with little (or less) experience of IM is unlikely to speed the process of document negotiation and execution.

There are also other factors to be taken into account.  Will your team of negotiators be self-managing?  Presumably not, so where does the supervisory element come from?  Who will provide the MI?  Who will take responsibility for the playbook?  Where are you going to physically locate the team?  What if one or more of them doesn’t work out (recruitment is far from an exact science)?  In light of all of these unknowns, it seems prudent to err on the side of caution.

How can we help?

If you want to chat about IM Phases 4 and 5, please just get in touch.  We have significant IM experience in-house – developed through Phases 1 to 3.  We have the scale and can build you a team that will perform.  We deliver at a cost point that is both reasonable and certain.  Managing derivatives documentation is what we do.  We aren’t a recent arrival on the scene – smelling a ‘Phase 5 dollar’.  We won’t offer you a service so strictly defined that it doesn’t really meet your needs.  We act as an extension of your own in-house team.  For us, handing back a negotiation because you’ve had your ‘three strikes’, it’s out-of-scope or it’s just too complex is not an option.

Whoever you talk to, please don’t leave it too late.  Nobody – nobody – has unlimited IM capacity and expertise.  Mike Tyson was right when he said that ‘everyone has a plan until they get punched in the mouth’.  If your plan is to bide your time and pick up the necessary negotiation resource nearer the event, you are going to end up bruised and bloodied.  You might still get the work done, but at what cost, within what timeframe and with what levels of quality?  Probably not the ones you had hoped for.

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