After a pandemic delay, Phase Six of the Uncompensated Margin Rule comes into effect today. Some companies are ready. And some are not.
The latest iteration of the rules, called UMR, is the final implementation created to prevent another repeat of the 2008 financial crisis. This is when insufficient collateral, as well as huge exposures to derivatives over-the-counter, led to government bailouts when those bets went south.
Major derivatives trading organizations have been preparing for this eventuality for some time, said Joe Midmore, chief commercial officer of OpenGamma, a collateral management platform.
“They will have all the documentation in place, appointed their custodian for segregation, a margin calculation mechanism and internal processes in place for the movement of collateral,” he said. Financial News.
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But some were caught off guard. These include companies that have just reached the $8 billion base amount of uncleared derivative contracts that would bring them within the scope of the new rules.
“They are the ones who potentially finish things at the last minute,” said Neil Murphy, commercial director at OSTTRA, an aftermarket company. He said FN that some of these businesses – which may include pension funds, smaller insurance companies and mutual funds where derivatives trading is not the primary focus – may have only learned that they would be integrated into the UMR in May.
But Murphy can’t really blame them: “Why are you preparing for regulations that you weren’t sure were in scope?”
As part of the post-financial crisis reforms, more derivatives transactions were transferred to exchanges or through clearing houses to reduce the risks of contagion. But some products are too complex to clear customs. UMR is the solution to limit the risk of uncleared derivatives by ensuring that these contracts have high quality collateral underlying them.
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Nearly 800 companies are now subject to UMR, holding between $8 billion and $50 billion in uncleared derivative contracts, according to estimates by the International Swaps and Derivatives Association. If they were to exceed a margin threshold of $50 million with a firm, asset managers would need to deposit margin with a custodian bank.
Most businesses would prefer not to put money aside in a deposit account if they can help it, because it is money that is not reinvested. It is also because some do not have the appropriate collateral management processes in place.
“It’s a long negotiation project, it’s a months-long process,” Murphy said. The checklist includes the integration of the bank with the business partner company in a three-way pact, as well as the negotiation of a complex agreement called the Credit Support Annex for Initial Margin.
He added that some companies use “tactical solutions” such as relying on counterparties to calculate margin, but the workaround can only be temporary.
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Indeed, a regulatory difference between the US and Europe has allowed US companies to rely more on their dealers to help calculate the initial margin. In Europe, regulators require companies to make their own independent calculations.
But Staffan Ahlner, global head of capital at State Street, said FN that just because regulations don’t require businesses to calculate margin themselves doesn’t mean they have to rely solely on whoever is on the other side of the trade.
“Any prudent organization should verify the information. It is sound business practice, with or without regulation,” he said.
For companies that were caught in the latter phase, most prioritized monitoring, looking to see if margin requirements for a counterparty exceeded the $50 million threshold. But their hand could be forced sooner than expected.
Based on the previous phases, it is expected that some companies will need to start showing margin with a custodian fairly quickly.
“There are some customers that we expect to show margin from day one,” Ahlner said.
Many State Street clients have already opened tri-party and custodial accounts with itself or others, Ahlner said. He expects more companies to open such accounts when they hit the threshold.
“What we expect is that, because the threshold is so low, a client can go from monitoring to posting guarantees fairly quickly,” he said.
Midmore recalled a company that was onboarded during phase four that estimated it would take four to six weeks to reach the $50 million margin threshold. But in reality, they had to post guarantees within five days.
“Companies with aggressive portfolio rotation are likely to hit these limits much faster than more passive, directional and long hedging strategies,” he said.
To contact the author of this story with comments or news, email Jeremy Chan