Opportunity and Caution Abound with Extra Year for UMR

On April 3, the Basel Committee on Banking Supervision (BCBS) and the International Organization of Securities Commissions (Iosco) announced that the implementation dates for the final phases of the uncleared margin rules (UMR)—phases five and six—would be pushed back by one year each due to the outbreak of Covid-19.

The extension was welcomed by industry participants, but as firms prepare to meet the new deadlines, they will be busy managing the economic and operational challenges caused by the pandemic. In early March, as the crisis was taking shape, WatersTechnology spoke with a handful of UMR service providers. They echoed one another on key issues for clients and said at the time that many of the firms coming into scope for phases five and six were underprepared. 

Under the new guidelines, phase five, which applies to firms with an average aggregate notional amount (AANA) greater than €50 billion (~$55 billion) in their derivatives portfolio, will now take effect on September 1, 2021. Phase six, for which the threshold will lower to €8 billion (~$9 billion), is set for September 1, 2022. It marks the second extension given by BCSB and Iosco, after splitting what was supposed to the fifth and final phase into two pieces in July of last year.

With the extra time, some see an opportunity to innovate. Luc Fortin, president and CEO of the Montreal Exchange (MX) and TMX Group’s global head of trading, says some might respond to the rules by moving away from over-the-counter (OTC) trades and toward exchange-listed derivatives and central counterparty clearinghouses (CCPs). While some marketplaces would already be poised to handle that kind of influx of OTC business—the Chicago Mercantile Exchange (CME) is the world’s biggest derivatives marketplace—smaller marketplaces, like MX, may scale up and enter the arena.

“Is there an opportunity for us, now that we’ve got an extra year to come up with something in our own CCP that could help accommodate and welcome this OTC business? Before, we had way too many other priorities and too many other things we needed to focus on that we couldn’t help provide a solution for this,” Fortin says. “But now that we’ve got an extra year, if we deem that there’s customer demand and an opportunity for us to play a role, we certainly will kick the tires on this.”

The number of firms coming into the scope of phase five is more than four times the number of those subject to the first four phases, and the number for phase six is greater than that, says John Pucciarelli, director of strategic initiatives at AcadiaSoft, a provider of risk and collateral management services for the non-cleared derivatives industry.

Prior to the rules, banks imposed collateral requirements known as independent amounts—the price of which were left solely up to the banks—on their riskiest counterparties, often hedge funds. Under UMR, banks are required to charge all their counterparties, and collateral will be bilaterally exchanged across the buy side and sell side. The price of that collateral will be prescribed by the regulation now, and will have to be in accordance with a standard initial margin model (SIMM) risk structure or a standard schedule, which lays out a percentage of notional for each different trade type.

For firms that are inclined to delay their UMR preparations in light of the new deadlines, Pucciarelli says that by the time they pick back up in January, they will have other regulatory hurdles to manage, such as the transition to risk-free rates from Libor, which is set to disappear in late 2021, a date that has not yet been changed. He estimates that about half of firms will continue with plans to comply with the previous deadline, with the rest kicking the can down the road.

“I would say that phases five and six are going to have a bigger learning curve,” Pucciarelli says.

Unlike the swap dealers who were affected during the earlier phases, those coming into scope later had more time to prepare. As a result, early firms were engaged immediately, whereas some later firms, especially in the US, have taken a hands-off approach and have viewed the onus as being on the dealers. Fortunately, Pucciarelli adds, a lot of free literature on the subject has been published, which can correct that view.

“I think education outreach is one of the big things that have changed, and just making sure that they understand how long the process takes—that it’s not that easy; that you don’t have as much time as you think,” he says.

Neil Murphy, business manager at TriOptima—which is part of CME Group and reconciles more than 80% of the world’s OTC derivatives transactions—said in March that preparations for phase five were well underway at the time, but there were differences in levels of preparation.

The headline UMR requirement is that firms need to calculate and exchange initial margin (IM), but there’s more than that under the hood. As an example, all the legal documentation will be completely foreign to lawyers and negotiators.

“The challenges we see with phase-five firms that are quite different to those firms in earlier phases is they kind of need a different set of tools. Even though they have the same IM requirements—it’s the same regulation they’re adhering to—they’re coming from a different starting point than, obviously, the dealer firms,” Murphy says.

Whereas bigger, dealer firms could calculate their SIMM numbers and risk sensitivities in-house, smaller players often don’t have the same platforms and risk systems in place. About 70 firms fell into scope during the first four phases, but Murphy expects about 300 to be affected by the upcoming phase, and they will need the most help thus far.

In addition to getting used to working with tri-party agents, entities that act as independent parties who manage collateral in transactions involving two other counterparties—uncharted territory for phase-five firms—includes sensitivity and IM calculations, and dispute management.

“If you look at the four or five different pillars or columns in terms of calculation, dispute management, margin calculation and settlement, phases one through four only focus on one of those,” Murphy says. “All of these, depending on the firm, may be something that a client will need help with, or they may need help with three of the four or five.”