The latest wave of initial margin rules for non-cleared derivatives has left market participants at sixes and sevens. Or should that be, at fives and sixes.

Phase five of the rules was marred by lengthy documentation queues as more than 300 mainly buy-siders scrambled to open thousands of custody accounts before the September 1 deadline. Fears are growing that firms caught in phase six, due next September, will face the same chaotic fate.

Many phase five firms were forced to rely on emergency monitoring arrangements and regulatory relief to continue trading.

“If we didn’t have that relief, we’d be in a mess,” says a margin official at a European bank. “Some of our biggest clients wouldn’t be able to trade with us.”

One European financial caught in the latest wave said it had aimed to repaper around a third of its counterparty relationships ahead of phase five go-live. In the event, it managed only half that target.

Two sources confirmed trading in some counterparty relationships had been paused. In one case this was due to a dealer saying it would not trade without full documentation in place. In the other this was due to a counterparty nearing the exposure ceiling for relief.

Custody onboarding was cited as the primary pain point, with the new rules bringing new challenges in both volume and complexity. Sources noted a slow pace of client approvals and “antiquated technology” at Euroclear, for example.

Some reported recent improvements at rival custodian Bank of New York Mellon, which has invested heavily in automating account setups since onboarding the first buy-side firm to its tri-party platform in 2018.

In their defense, custodians argued the main cause of the logjam was clients delaying their onboarding arrangements to the last minute. But they acknowledge improvements could be made.

“We [custodians] need to find more and better efficiencies in mobilizing assets and effectively managing the data flow. The only sustainable way forward is through technology,” says Staffan Ahlner, global head of collateral at State Street.

The paperwork pile-up has left market participants concerned about the sixth and final wave, when an estimated 800 firms will have to post regulatory initial margin for the first time, comprising more than 10,000 relationships.

“Something needs to be done,” says the bank margin official. “The custodians are the blockers and in the next phase there are more people in scope.”

Gimme five

Phase five of the non-cleared margin rules applies to firms with more than €50 billion/$50 billion equivalent in average aggregate notional amounts of over-the-counter derivatives outstanding.

In-scope firms must post and receive collateral against their trades in segregated custody accounts. The necessary paperwork includes new credit support annexes, custodial account control agreements and eligible collateral schedules – alongside model validation, technical connectivity and testing.

Bottlenecks at custodians bedeviled the first phase of the rules in 2016, when banks were unable to face up to half of their counterparties on day one of the new regime. To ease the operational burden, global rule-makers granted relief in 2019 to firms with bilateral margin exposure of less than €50 million/$50 million, allowing them to trade without documentation.

Many phase five entities took advantage of this relief, which ensured trading didn’t grind to a halt in the run-up to the deadline. However, more than 100 accounts were required to sign last-minute margin monitoring agreements, says the bank margin official.

There’s still a notable tail of phase five firms completing steps to get fully functional with all their counterparties

Tara Kruse, Isda

The monitoring agreements are not a regulatory requirement, rather a safeguard for banks to make sure exposure levels don’t creep up to the €50 million limit. The agreements are often structured with sub-thresholds. So, for example, if a client hits €20 million in bilateral exposure amounts, the bank may insist that the client puts in place custody documentation. If the client hits €35 million in bilateral exposure, the bank may cease trading with that counterparty.

Although the relief largely staved off a breakdown in trading, many phase five firms still failed to meet repapering targets.

“Phase five entities didn’t complete their preparations with everybody they wanted to for September 1, but there hasn’t been a cliff edge and firms are continuing to trade with those counterparties they did manage to complete their preparations with,” says Tara Kruse, global head of data infrastructure and non-cleared margin at the International Swaps and Derivatives Association.

“There’s still a notable tail of phase five firms completing steps to get fully functional with all their counterparties. We know it takes a lot of work to get ready for initial margin and the queues have been long, so there’s some concern over whether there will be an impact for phase six,” Kruse adds.

Another complication is the nature of the custody arrangements. In previous phases, a mainly dealer-led cohort widely adopted tri-party services, in which an agent fulfils various collateral requirements, including automated settlement, once transfer amounts are agreed. Buy-side firms in the latest wave took mixed approach, with some opting for the more manual third-party model, which they currently use for variation margin. This approach sees the pledging party select and value collateral for transfer, while the custodian provides settlement into the counterparty’s segregated account.

Paper, and more paper

Amongst the pile of onboarding documents for phase five clients, eligible collateral schedules proved especially time-consuming. The schedules specify the instruments counterparties can post as margin and their associated haircuts. Typically heavily negotiated, the back and forth between counterparties can go on for weeks – or even months.

At Euroclear, clients seeking to make changes to these documents, for example adding or removing a government bond to or from the collateral mix, were pushed to the back of the queue, leading to lengthy delays.

A spokesperson at Euroclear says all pairs for which “appropriate documentation” was received by the May 28 community onboarding deadline had been implemented. “All these accounts were ready to exchange by September 1,” says the spokesperson.

Tilman Fechter, head of banking, funding and financing at Clearstream, says the vast majority of delays in onboarding at the Luxembourg-based custodian were due to documentation being submitted after advised cut-off dates. “Clearstream, like many other market participants, will continue to further refine and adapt its processes in the coming months based on lessons learned from phase five, as we have done for the preceding phases,” he says.

BNY Mellon, which took the brunt of the phase five burden, opening “thousands of accounts”, aimed to accelerate eligible collateral schedule negotiations via its automated ‘Rule’ system. The service allows counterparties to modify schedules online, cutting negotiation time to days or even hours, the firm says.

A one-month extension on the application deadline for clients using Rule ensured the majority gravitated towards the automated tool.

“The Rule service was relatively smooth,” said a manager at a US buy-side firm. “It was tricky getting access to the platform, but BNY Mellon did a lot of the heavy lifting.”

BNY Mellon has also created standardized templates for account control agreements, which helped to cut onboarding times from months to weeks, users say.

These kinds of automated processes must be more widely adopted to smooth the path for phase six, according to one technology vendor. “Hopefully if people understand how difficult this process has been, maybe they’ll start to realize that they need an automated solution to deal with it. Eligible collateral schedules are definitely one of the bigger, sticky processes. It starts with the negotiation but it’s the amendment process as well,” says John Pucciarelli, head of industry and regulatory strategy at Acadia, which onboarded more than 300 parties to its AcadiaPlus initial margin communications platform. The service handled 2,000 regulatory initial margin credit support annexes and 5,000 margin monitoring agreements, Acadia says.

Some have sympathy for dealer-focused custodians such as Euroclear and Clearstream, whose strict entry requirements make it challenging to onboard buy-side firms.

“The custodians will have different motivation levels for how hard they sell to latter phase firms,” says Chris Watts, director and co-founder of MarginTonic, a consultancy. “For some, the business model has historically been not to take on smaller buy-side firms. Some have strict onboarding requirements, are dealer-led and if it wasn’t for initial margin they probably wouldn’t be making a play for the likes of hedge funds who may not meet their credit profile requirements.”

Euroclear aimed to smooth phase five onboarding via its “pledgee representative” model, allowing buy-side firms to be sponsored on to the platform by their existing custodians. The sponsor effectively takes on the grunt work required to onboard the client. It would then continue to provide a limited number of custodial services to the client.

Many third-party agents, however, have not offered the arrangement to their clients. Some cite competitive concerns about steering business to rival firms. One custodian, which is still evaluating the model, highlights “operational risk and legal challenges”.

At least two third-party agents are understood to have sponsored clients into the tri-party regime in this manner. Euroclear says there were more, but would not confirm numbers.

Absent any relaxation in onboarding requirements, wider take-up of this model could be critical for onboarding phase six firms.

“As we go into the latter phases, custodians with stricter onboarding requirements are more reliant on other custodians taking up client onboarding on their behalf,” says Watts. “The likelihood is that those custodians will end up taking a far smaller chunk of phase six firms. As a result, and perhaps more importantly, there’s also a risk to their dealers’ phase six needs if their buy-side clients cannot find a way to onboard.’

Prior planning…

Many custodians are already taking action to better prepare for the final wave.

For example, BNY Mellon is overhauling documentation to welcome a new breed of clients in phase six.

“Because we know pension funds, 40 Act funds [ie, mutual funds and closed-end funds] and other types of entities are going to be part of phase six, we’re going to revamp the account control agreement one more time to make it more client friendly. It’s mostly driven by how the regulations apply to new types of in-scope vehicle with different ownership structures,” says Ted Leveroni, head of margin services at BNY Mellon.

State Street is modernizing its infrastructure and is planning to roll out API-based onboarding for phase six. The third-party custodian is also launching a new tri-party platform, which it hopes will appeal to buy-side clients.

Ahlner of State Street says custodians can use the retail banking industry as an exemplar for onboarding.

“As the institutional part of the financial industry, we have a lot to learn from the retail world, where you can open an account within minutes. In our world it takes months. There are different challenges and connectivity, but that gap between retail and institutional is huge,” he says.

One surprising outcome for phase five was the number of buy-side firms using the full tri-party service; around half of buy-side firms onboarded at BNY Mellon. While the model is typically considered as more expensive than third-party segregation due to its broader scope of services, such as collateral allocation, eligibility checks and application of haircuts, Leveroni says this is not always the case. Collateral optimization means savings for users. Plus, clients who take the third-party route will often end up paying extra for bolt-on services from other providers.

“Depending on the number of counterparties a client has, tri-party can cost the same or less than third party. Depending on the entity and counterparty mix you have, we had instances where tri-party was less expensive, even though it comes with so many more bells and whistles,” says Leveroni.

Isda’s Kruse urges phase six firms to start their custody work as early as possible, given the addition of more counterparties and custodians in jurisdictions that have not yet been roped into the regime and may not have updated their infrastructure. Countries in Asia, for example, are likely to be caught in the phase six dragnet for the first time.

“There’s therefore a need for the industry to examine the documentation for those custodians to ensure it’s fit for purpose and that all the operational elements still work for regulatory initial margin,” says Kruse.

For phase six, it may not be custodians that pose the highest risk of logjam. The final wave of rules will apply to firms with average aggregate notional exposures down to €8 billion/$8 billion, meaning many are unlikely to ever hit €50 million exchange thresholds or segregate collateral in custody accounts.

“Will phase six firms really be using custodians and pledging collateral? Probably not. Even in phase five, many firms will be slow to go over thresholds. Even with our highest exposure we’re only around 10% of the exchange threshold so it’s going to take some time,” says a manager at the phase five European financial.

The manager expects bigger problems around margin monitoring.

Acadia’s Pucciarelli agrees: “Our challenge now is to identify who the phase six entities are and get them into initial margin monitoring right away. It’s also an opportunity to engage with dealers and firms need to start doing that now. We used to recommend that firms start doing these things in January but phase six is going to be the biggest one yet.”