Phase 6 of the UMR is fast approaching. Here’s why it will be a game-changer in the derivatives market
By Joseph Spiro, Hazeltree
Seasoned derivatives traders know that tougher new rules on uncleared margins have penetrated deeper into their industry. Coming in late summer this year: Phase 6 of UMR implementation, an extension of UMR regulation to a new level of companies.
You could call it the long tail of the regulatory response to the financial crisis: the new rules are all aimed at mitigating the systemic risk of derivative exposures. US regulators, through the CFTC, as well as global regulators, have largely followed the design and deployment stages of regulations. With each new phase, more firms come into scope and must comply with initial margin rules, monitor average aggregate notional amount (AANA) levels, and codify counterparty relationships more rigorously. Phase 6 will affect a much wider group of asset managers and counterparties by lowering the AANA threshold to $8 billion to be in scope.
The outstanding questions, which become more pressing with each passing day, include who, exactly, is in scope. There are also multiple variations of “what” questions, including:
- What needs to be done comply with phase 6?
- What is the actual lead time required prepare (given the amount of work required and the very limited resources available to outsource)?
- And especially, “so what?“What’s the worst that can happen if the Phase 6 deadline comes and goes? There is a twist: it is not the regulators who pose the greatest threats.
While September 2022 may seem distant, in regulatory terms it is fast approaching. Preparation requires work on many fronts and should begin immediately to get businesses ready for September. There is a lot at stake, as the consequences of not being prepared for Phase 6 could be severe, as non-compliance could reduce or even halt trades.
For businesses entering the scope, Phase 6 also promises to require a new level of agility and coordination with their back office to meet compliance standards and reduce costs. Thus, derivatives traded for a new band of hedge funds, other asset managers and their counterparties will soon enter a new, more demanding era.
What must be done to comply?
Regulators gradually implemented unmatched margin rules governing OTC derivatives trading collateral following the 2008 financial crisis. Now, funds that fall within the scope will require that two trading parties post initial margin held in separate accounts. The rules also prescribe how the margin is calculated and what types of collateral can be used.
Managers need to answer several questions:
- Are we in the perimeter? (AANA calculation required)
- How will the initial margin change?
- Do I have the right service providers lined up?
- Are the counterparties informed?
- Have we explored options to mitigate or avoid the impact of the rules?
What is the timeline? Preparation takes longer than you think
There’s a reason regulators have set an extended implementation period for UMR compliance – it takes a long time to prepare for these rules. Only the data management component, to load positions into a database and normalize the data to even allow ANAA calculations, is very cumbersome for most businesses without sophisticated IT resources.
Compliance also requires firms to determine their initial margin requirements with their swap brokers using either the grid or the risk-based SIMM methodology, which has its own complications and nuances. A range of service providers – lawyers, technology providers and custodians – also need to be aligned and consulted, and significant anecdotal bottlenecks are already beginning to form which could make delays more taxing even at this early stage. .
There’s more: assuming a fund doesn’t create a workaround to reduce its ANAA or initial margin – to get below the $50 million threshold – many will also look to consolidate their unmatched OTC positions in order to minimize the number of separate collateral agreements required.
Ultimately, a back-of-the-napkin estimate can arrive at an 18-month delay if the back office is unable to follow parallel tracks on the necessary steps.
The “so what?” What could go wrong?
For companies that fall into the scope, the net effect will be much more attention to regulatory details and the costs they entail. Failing to prepare is not an option for managers: Swap brokers, who are subject to rigorous regulatory scrutiny, will not trade without adequate counterparty compliance.
But even designing a workaround requires fund managers to put in place processes and tools to manage their AANA in real time to avoid falling into the scope of UMR regulation without realizing it. Companies that are informed in real time will be rewarded, in some cases by reducing risk and staying below regulatory thresholds.
Why Phase 6 is a game-changer for derivatives trading
Phase 6 represents a brave new world of derivatives compliance, one that favors companies that aggressively manage it. Beyond the extensive preparation it requires, Phase 6 will elevate certain back-office functions involving safeguards and AANA. Phase 6 brings a new bonus to transaction efficiency: Managers who are not aware in real time of the new financial implications of transactions can unduly weigh on their company’s bottom line.
Joseph Spiro is Director of Product Management at Hazeltree. He has been in the warranty management industry for over 20 years. Prior to joining Hazeltree, Joseph served as Head of US Collateral at Société Générale, where he was a key member of the dealer community responsible for the introduction of UMR Phase 1 in 2016, as well as than the following phases. Prior to SG, Joseph held senior positions at Merrill Lynch, Deutsche Bank and BNY Mellon. Joseph has contributed to ISDA and other industry working groups on the subject of collateral management and has contributed to ISDA publications in the area of collateral management. At Hazeltree, he is focused on helping Hazeltree buying customers improve their collateral management process, increase efficiency, reduce risk and increase liquidity.
Joseph holds an undergraduate degree in economics from Rutgers University and an MBA from New York University’s Stern School of Business.