As smaller banks and asset managers brace themselves for new rules covering how they trade exotic derivatives come into force, lobby groups and vendors are joining forces to create technology that, trading firms say, may be too difficult to manage in-house once the big bang hits.

Later this year, and into 2020, these firms will be required to calculate and exchange initial margin on their derivatives trades that don’t pass through clearinghouses. For many, this will be the first time they’ve had to handle such complex calculations in-house. Although the very largest dealers have been through this process already, experts warn that these smaller market participants may not be ready for the burden that is about to fall on them—and that the clock is ticking.

“Time is running out,” says Nosheen Amir-Ebrahimi, managing director at IHS Markit. “Phase four is in six months, phase five is in 18 months. And if you look at the experience from phase one and two, they have taken between 18 and 24 months to get to where they need to in terms of compliance.”

The regulatory changes, jointly developed by the Basel Committee on Banking Supervision (BCBS) and the International Organization of Securities Commissions (Iosco), will take effect in September 2019 and September 2020, the fourth and fifth phases of implementation, respectively. While it may be tempting to think of the margin rules as mature and bedded in at this late stage, these two phases will have an enormous impact on the largest segments of global derivatives markets. They are anticipated to bring more than 1,000 banks, asset managers and counterparty firms with margin valuations exceeding €750 billion ($854 billion) in phase four and €8 billion ($9.1 billion) in phase five into scope of the uncleared margin rules.

Vendors have responded accordingly. On January 17, several organizations launched IM offerings in preparation for the next deadline, including the International Swaps and Derivatives Association (Isda), which announced that it has joint forces with London-based law firm Linklaters to launch Create IM, the first release of its Create negotiation platform. 

That same month, IHS Markit and AcadiaSoft forged an alliance to enable their margin automation platforms to interoperate, and the CME Group subsidiary, TriOptima launched an initial margin analytics tool. In February, several other firms such as CloudMargin and Cassini Systems—in partnership with Margin Reform—have made subsequent announcements on tech offerings and consultancy services in the run-up to the next phases.  

Andrew Kayiira, director of product development at Isda, explains that the time is finally ripe for providers to ramp up technology releases in response to this regulatory pressure. He says the industry is ready to move away from paper contracts and manually led negotiations.

“I don’t think at the time [in previous phases] the legal industry was ready to make the shift to an electronic form of negotiation with documentation,” Kayiira says. “The timing now coincides with a regulatory push—but also it coincides with the fact that Isda has published documents that made it allowable for us to do digitization.”

There is also danger in distraction. IHS Markit’s Amir-Ebrahimi says that while the uncertainty surrounding the UK’s planned departure from the European Union at the end of March 2019 has occupied much attention, the timelines here are critical. Firms that will come into scope over the next two years must begin prioritizing now before it’s too late, she says. 

Under The Scope 

The IM requirements are mapped out in the global framework agreed by the Basel Committee and Iosco, and are adopted under the European Market Infrastructure Regulation (EMIR).

Affected firms are required to exchange margin on over-the-counter (OTC) derivatives contracts that are not cleared through a central counterparty clearinghouse. The regulation was first introduced by BCBS and Iosco in September 2016 and is being phased in over four years, capturing counterparties depending on their categorization and derivatives volumes—otherwise known as their aggregate average notional amount of non-cleared derivatives.

Bank of Montreal (BMO) Capital Markets is just one of the many firms that will come into scope in phase four of the IM rules in September 2019. Liz Lindsay, director of BMO Capital Markets, Collateral Management Group, further explains that the strain on smaller firms that are stifled by restrictive budgets, within phase five, is likely to also increase pressure on larger institutions—ultimately requiring them to pick up the tech bill. 

In some cases, many pension or hedge funds will struggle to implement industry technologies and services, including Isda’s Standard Initial Margin Model (Simm), a common methodology used to calculate initial margin for non-cleared derivatives. Many of the platforms used to digitize the initial margin process are largely unattainable to smaller counterparty firms—including those used to calculate margins, manage the negotiation process and exchange collaterally more effectively.

“Those firms are looking to the dealers to provide some of these services and in fact pay for some of these services. Otherwise, it turns into a fairly manual process for the dealers,” she says.

There is also growing concern that firms in phases four and five are less educated about the extent of the regulatory challenges ahead.

“Phase four and phase five are capturing firms of decreasing size, and in reality, often a decrease in resources available to look at regulation related to derivatives portfolios,” says Thomas Griffiths, co-CEO of TriCalculate, TriOptima’s IM calculation service. “So they are really the types of clients that require some external help.”

Digitizing IM

In response to the rules, Isda launched Create IM on January 31, following the release of a beta version in September 2018. The soft launch attracted just over 50 institutions to test the technology, amounting to more than 540 users. The tool enables relevant firms to digitize initial margin processes, including managing, executing, and simultaneously negotiating IM documentation with other counterparties. It is designed to allow clients to capture, process and store legal data while delivering it in a structured electronic format.

“We have built-in interactive dashboards for firms to utilize, with audit features for workflow transparency throughout the whole lifecycle of the negotiation process,” explains Isda’s Kayiira. “Firms can benefit from automatic reconciliation of both standard elections within the Isda standard framework, but also as these are OTC [trades], we allow for the flexibility of bespoke provisions.”

Create IM is a web-based product with built-in user management features that will allow counterparties to manage workflow and designate front-office roles by job function, such as administrator or manager, and those responsible for approving contracts. The tool will provide an environment for collaboration and communication, where firms can directly comment on IM terms and interact with each other on live contracts. Kayiira emphasizes the value of digitizing the negotiation process to enable clients to capture data in a structured format and extract insights to be used elsewhere within a firm to support functions such as risk management, resource management, analytics, and other applications. The data can be downloaded or delivered via individual counterparty systems using application programming interfaces (APIs).

“It is this access to structured legal data, where it is frankly the first time you will have legal data in front of you in various forms for you to pull into your systems or send externally,” he explains. “With the connectivity, they can leverage this to read and write APIs and then allow for firms to fully automate the process.”

Targeting a similar space, TriOptima introduced TriCalculate, a risk analytics tool for initial margin compliance, which calculates IM and informs trading decisions to reduce margin costs. The technology provides insights into IM calculations to enable clients to identify and prioritize counterparty negotiations. TriCalculate is a standalone offering within TriOptima’s product suite, which also includes its TriResolve reconciliation and reporting solution, its TriResolve Margin collateral management service, and integration with AcadiaSoft’s Initial Margin Exposure Manager. The combined services enable clients to access the offerings through a single interface.

“The workflow for initial margin is important,” explains TriCalculate’s Griffiths. “TriCalculate provides the analytics and calculations for initial margin as part of the full TriOptima suite of services, which ensures clients have one seamless workflow.”

TriCalculate is currently up and running with some clients, though Griffiths says there is more urgency in the run-up to the next deadline because such a vast number of firms will be caught by the rules.

“There are potentially over 1,000 firms coming into scope in phase four and five, so it is really important that firms start to look at the analytics sooner rather than later. There will be a real rush coming into the deadline. So the sooner people get started, the better,” he adds.

Bridging Solutions

While some vendors are developing technologies to service the growing market, others are forming alliances to strengthen their competitive edge. On January, IHS Markit announced a partnership with AcadiaSoft to provide an integrated offering to mutual clients, similar to TriOptima’s and Isda’s collaboration with the provider on January 30. On February 20, SmartStream teamed up with Numerix to provide a packaged tech offering for collateral management of over-the-counter derivatives. 

As the industry’s regulatory deadlines near, a key objective of the alliances is to provide a wider variety of technology options to clients and reduce the cost of compliance. A common variable to the IM network is AcadiaSoft, which claims to serve as many as 95 percent of firms within phase one, two and three of rules.  The AcadiaSoft hub provides a community-based infrastructure and integration services using common adapters and APIs. The common platform enables other third-party providers to connect into the system and interoperate with other applications. 

“Providing those common repeatable adapters saves everybody from having to build their own point-to-point integrations. That is the key benefit of a community-based infrastructure where you mutualize a lot of the cost and technology decisions into something like AcadiaSoft,” says Richard Barton, head of strategic new product development at AcadiaSoft.

The AcadiaSoft hub is designed to provide an overview of the initial margin process but although it offers a variety of margin and collateral management services within its single platform, counterparty firms can choose to use a range of other technologies provided by partnering firms. Much of the industry has had to adapt to a different competitive nature in bridging solutions to help to provide a more flexible workflow and automate initial margin lifecycle processes through integrated platforms. 

“There is overlap with Acadia in what we do, and we understand there are competitive angles, but what we are trying to do is enable customers that might want to use AcadiaSoft for a specific component of their margin workflow and IHS Markit for another component,” IHS Markit’s Amir-Ebrahimi says. “Even if we might be competing, we want to make sure that we connect with each other so it’s easier for customers to ultimately have a more holistic solution.”

Taking to the Cloud

As vendors are rolling out and testing platforms to service the next wave of counterparty firms, some banks and asset managers are turning to emerging technology to offload their margin and collateral management functions. On February 7, Deutsche Bank announced it will be integrating CloudMargin’s web-based platform, which is stored on a public cloud. This will provide the bank and its clients with individual login portals for visualizing and managing the collateral management process. Users will have access to the same version of record, designed to minimize operational risk and eliminate discrepancies. 

Joseph Macdonald, global head of collateral optimization trading at Deutsche Bank, explains that one of the key objectives to using cloud technology is to benefit from automated upgrades and software updates—enabling all users to access the most recent version of the collateral management lifecycle. 

“The alternative to the cloud is on-premises solutions and these typically, by the time they are integrated into our platform, are already regarded as obsolete and needing to be updated,” he adds. “But with the cloud, we are always on the latest version and every time something changes, we get the benefit of that and so does every single one of our clients logging into the platform.”

Although many financial firms are still reluctant to embrace cloud technology for managing critical functions, Macdonald explains that the decision to introduce CloudMargin was an obvious and practical one. He says cloud providers have come a long way in the development of their security architecture to meet the standards of heavily regulated financial institutions.  

“They do all of the kernel patches and have a whole [security] program for that. That is their job and they are real specialists at making sure the servers they provide and the service they provide is secure at that level,” he adds.

Deutsche Bank is also working with CloudMargin in an effort to provide additional services for its clients in the run-up to phase four and five of the initial margin rules for non-cleared derivatives. As tier-one banks and asset managers endure a heavier serving of regulatory scrutiny under the rules, the partnership with CloudMargin will digitize the process for Deutsche Bank’s smaller counterparty clients and enable them to utilize the service for free through an individual login. 

The Compliance Roadmap 

As the countdown continues, many are waiting for a response to the advocacy letters submitted by Isda in 2018 to  BCBS and Iosco to request relief for some smaller firms that will be subject to the initial margin rules in phase five of the implementation. Statements published by the industry body outlined that the final phases will present “serious logistical challenges” due to the volume of firms that will be brought into scope over the next 18 months. It showed that many firms with a low IM threshold, of under $50 million, will not exchange IM under some circumstances and their compliance with the rules would offer little benefit to regulators in measuring systemic risk for the global markets. 

“The scary thing is the sheer volume of the 2020 phase-in. We’re anticipating on-boarding hundreds of counterparties in that phase and whatever the number is, it multiplies [the workload] by two. So there is a considerable workload to be done,” explains BMO’s Lindsay.

Some of the initiatives have looked at raising the gross notional threshold to $100 million, relieving some of the burden on the industry and removing phase five firms. Other suggestions include the removal of foreign exchange swaps and forwards from the notional calculations, as well as offloading the burden of phase four and five firms from using globally accepted IM models, including the Isda Simm. Macdonald explains that proposed initiatives would defuse the pressure on smaller firms to implement costly technology systems and ease the pressure on the rest of the industry waiting to onboard or set up multiple digital relationships with hundreds of firms expected in the final phase. 

As a rule of thumb, firms that fall under the $50 million bilateral threshold are not required to be papered for IM agreements—although if they breach that amount, they will subsequently be required to do so for every trade—and therefore many believe that this is a key driver in raising the requirements to $100 million and alleviating unnecessary strain on an already heavily regulated industry. Some believe that only time will tell on whether relief will be granted for the final phases, but others are hoping that the ambiguous nature of the regulation and the unnecessary challenges it presents will allow the pendulum to tip in favor of reigning in the scope of the regulation. 

“If we are not required by the rules to actually post the IM for those with a 50 million threshold, and do not have to go through all of the paperwork and all of the manual setup that we currently have, this will allow us—without actually changing the rule itself or changing the spirit of the rules—to solve the bottleneck problem of trying to bring in over a 1,000 firms on board on one date. It will give us a better runway to do that,” says an executive at a global investment firm.

Hopes are fading that this will be approved, however. While the industry awaits a verdict, as experts have pointed out, little time remains.