For institutions involved in uncleared derivatives markets, the second phase of BCBS-IOSCO margin rules has been underestimated in scope and complexity since the rules first appeared on the scene in 2013. Nicknamed the “big bang” due to their all-inclusive nature, these rules could have massive consequences to financial markets when they’re implemented on March 1, 2017.[1] Given that the exchange of variation margin (VM) is already commonplace in the uncleared derivatives world, especially among big dealers, it begs the question why this second phase is causing such a stir.

How national regulators have responded

National regulators have responded to the BCBS-IOSCO guidelines by each publishing their own stringent requirements around eligible collateral, applicable haircuts, operational requirements and settlement timing—all of which must be reflected in the legal documentation governing each trading relationship. The International Swaps and Derivatives Association (ISDA) estimated that circa 200,000 documents need to be re-papered.[2]

What institutions (big and small) can expect

The rules will apply to large and small institutions alike, but the impact to operational procedures, system enhancements, commercials and their ability to meet the regulatory deadline could vary considerably. Small counterparties, including buy-side firms such as pension funds and insurers, may potentially find themselves unable to trade uncleared derivatives and forced to liquidate assets come March 1 to free up collateral. The resulting liquidity drain could increase investment risk by preventing firms from hedging existing positions and threatening best execution—a major theme of another key impending regulation, MiFID II.[3]

Large institutions may need to categorize their trading partners into: (a) those who can follow standardized procedures and be ready to margin according to the rules; and (b) those who might require more unique tailoring in terms of operational and documentation nuances when agreeing, issuing and settling calls.

Challenge 1: Re-documentation

The mammoth re-documentation underway is arguably the riskiest aspect of this implementation—particularly in light of the new bifurcated document hierarchy that has emerged. Figure 1 shows the main VM credit documentation options market participants are facing when margining according to the rules. Initial margin, both regulatory and house, add yet further complication to the BCBS-IOSCO documentation web.

Figure 1: CSA Re-Papering Options

Variation Margin
Repapering Methodology for Attaining Regulatory Compliance Legacy Trade Coverage
New Trade Coverage
ISDA VM Protocol[4] 1) New CSA Option Existing CSA Brand New CSA
2) Amend CSA Option Existing CSA, Amended to be Regulatory Compliant
3) Replicate & Amend CSA Option Existing CSA Brand New CSA, Reproducing Terms in Existing CSA to be Regulatory Compliant
Bilateral Negotiation 4) Amend CSA Existing CSA, Amended to be Regulatory Compliant
5) New CSA Existing CSA Brand New CSA

Initial margin requirements created a documentation stir when they went live in September 2016, especially in the custodian documentation space, however the challenge is many times greater for VM as in the majority of cases, new regulatory credit documents cannot be created from scratch as their terms have been heavily negotiated.[5] In fact, just over a week ago, industry CSA readiness was at a mere 4.43%.[6] ISDA’s VM Protocol aims to help counterparties amend or update existing agreements by supplementing regulatory terms. Most counterparties have opted to amend their legacy agreements given the pressure legal resources and budgets are under, but many have chosen to bypass the Protocol and to bilaterally amend in order to avoid having the increased disputes that could come with negotiating both legacy and protocol documents in parallel. This has created operational complexities of its own as downstream credit and margining systems need swift amendments to their trade-stamping and margining-account logic in a matter of weeks.

Challenge 2: Late discovery

Late discovery has been a key theme for VM compliance, as entities might struggle to determine if they are in or out of scope. This can have severe knock-on effects to the book of work needed for readiness, as in the case of 1940 Act U.S. mutual funds, Irish funds and Luxemburg funds, which resulted in the build out of additional segregation flows for VM with all the operational, technical and legal investment required. In this circumstance, ISDA’s VM Protocol did not have provisions until 27 January to allow third-party segregation, whilst custodians have proved to have limited capacity for onboarding.

From a workflow perspective, late discovery has compromised the scale of control over enhancements in preparation for the compliance deadline. The result is a huge volume of processes that operations teams could need to handle manually—and the increased operational risk that comes with that. In the short term, we might see an increase in failed settlement of collateral bookings. Any risk around collateral delivery fails could have a further knock-on impact on capital charges and Required Stable Funding (RSF) obligations resulting in a lower Net Stable Funding Ratio (NSFR), adding to banks’ funding and liquidity burdens of providing the required collateral.

The countdown is on

Recognizing the complexity and following from requests by ISDA for a phase-in of the rules, some regulators are offering a six-month transitional relief period into the new margin reality. First in 2016, Singapore, Hong Kong and Australia announced the relief, followed by the US CFTC, which offered the same last week. Just today the Swiss regulator announced an equivalent relief period—with rumors surfacing of European and South Korean regulators’ plans to potentially follow suit. This leniency might help address documentation readiness concerns, especially where the smallest fish in the pond are “being handled by dealers as a lower priority,” risking their access to trade and causing “unintended consequences on risk concentration and stress on the financial system”—a stark juxtaposition to regulator intentions.[7]

However there are concerns that in the process, transitional relief potentially could:

  • cause confusion as to who should sign documents for March 1 and how trades should be priced
  • put additional pressure on firms’ change budgets and operational resources to enhance their counterparty categorization
  • cause temporary shifts in firms trading away from counterparties bound to comply with Canadian, Japanese or US Prudential Regulations as of March 1 (should these regulators not follow suit with transitional relief).

As we currently stand, NFC-counterparties subject to only CFTC rules might be clear winners from the current state of regulatory fragmentation, especially given the gap in infrastructure readiness between the smaller and larger players.[8]

New requirements and late discovery are likely to continue to surface in the run up to go-live; the capacity to deal with them and the unintentional knock-on effects might have a large impact on how smooth the transition will be into the second phase of Margin Rules. What happens in the aftermath of the Big Bang on March 1, 2017 could be one to watch as markets could be disrupted with fragmentation across jurisdictions and counterparties. Transitional relief may be the solution, but it could bring its own operational and commercial complexities.

What’s clear is that firms cannot rest on their laurels and should swiftly evolve in infrastructure, transparency and agility regardless of whether the various transitional relief announcements require them to fully or partially comply by March 1, or give them an additional 6 months to get their house in order.

Acknowledgments: With thanks to Petra Yazbeck and Tim Burgess for their contributions to this blog.

[1] Beginning March 1, 2017, all in-scope entities, regardless of their aggregate average notional amount (AANA), will be required to exchange VM for new trades and certain trade novations.

[2] “All Eyes on March 1” ISDA Blog, January 31, 2017.

[3] Under MiFID I, firms were obliged to take “all reasonable steps” to achieve the best possible results for their clients. Under MiFID II, firms will instead be required to take “all sufficient steps.”

[4] 2016 Variation Margin Protocol

[5] Agreements include, but are not limited to, various versions of the CSA (1992/1996/2004/2006), French and German master agreements, and asset-specific agreements (e.g., IFEMAs for FX CSAs).

[6] “Time is running out” ISDA Blog, February 9, 2017.

[7] SIFMA Request for Relief, December 16, 2017.

[8] NFC- is an EMIR categorisation of non-financial counterparties below the clearing threshold

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