I. Regulatory context
Initial margin is the exchange of collateral to prevent the margin period of risk (i.e. liquidation period beginning with the last exchange of collateral supporting exposure under an ISDA master agreement). Variation margin on the other hand, isthe collateral posted to cover immediate default risk for the same exposures under an ISDA master agreement.
Counterparties are most likely to default at times of market stress (prices are more volatile which in turn can harm the value of the collateral posted). In order to (i) promote central clearing, and (ii) mitigate counterparty risk for OTC, UMR (uncleared margin requirements) new rules defined under EMIR regulation require counterparties to post both initial and variation margins to act as a buffer.
EMIR is enlarging the scope of counterparties subject to UMR, and more specifically Initial Margin, according to a threshold drop agenda phasing out from 2017 to 2021:
The final phase, which will be enforced by September 2021 and applies to any firm with an average aggregated grossnotional amount of €8 billion (or equivalent) outstanding uncleared OTC derivatives, raises the most significant EMIRimplementation challenge for buy-side firms, as IM must be exchanged both ways between counterparties in the form ofeligible collateral.The transfer must be performed free of setoff.
IM must be calculated based on set methodology (either by using anapproved model such as SIMM - Standard Initial Margin Methodology depending on risk factors and agreed data sources,or by the regulatory prescribed table known as the "Grid") and segregated on a third-party account backed by a custodial structure established by the leading custodians (e.g. Clearstream, BONY, Euroclear).IM is required to be posted between two counterparties only if the exposure is greater than €50M, yet bilateral agreementsmust be put in place without regards to the trading activity between counterparties.
Under each ISDA master agreement,an IM bilateral agreement will be set under an IM CSD (Credit Support Deed under English law), CSA (Credit Support Annexunder US law) or CTA (Collateral Transfer Agreement under European law).Each custodian will put in place a bilateral custody agreement with each party posting collateral (providing segregatedaccount to hold IM collateral) as well as a security agreement (triparty agreement between the parties and the securitiesintermediary) According to ISDA, with over 1100 firms expected to come into scope, September 2020 deadline could be the IM "bigbang".
As such, an early start on compliance effort will be critical.
II. What is at stake?
After each firm determines whether it is in scope, it will, for each of its counterparties, draft and deliver IMdocumentation, negotiate and execute them.
Each firm will also have to capture, store and maintain legal data, that willfeed operating systems and used by compliance and middle officers to control cohesiveness with regulation and assettransfer accuracy.
Alongside, the whole trade lifecycle will be impacted, starting with the choice of a custodian, and how IM will besegregated. Then, one critical task will consist in the setting of collateral schedules: the selection, the posting and thedelivery of eligible collateral.
From an operational standpoint, the main challenge will consist in defining how to efficientlyissue or respond to a margin call.Finally, settlement is equally critical, as all trades will be subject to continuous screening, monitoring, reconciliation, andreporting.UMR rules imply major change management challenges, with a truly multi-directional and cross-functional approach asfirm organization is globally affected.
Buy-side firms that are directly subject to EMIR will also be required to undertake further monitoring and assessment of their margining arrangements. Such buy-side firms will have to perform validation, back-testing and auditing assessments on the IM model they use.
III. Triparty collateral management
The triparty model can be an efficient solution for asset managers, as it enables them to invoke equities as collateral instead of cash or sovereign bonds, thus allowing them to reshape their funds' asset structure.
The triparty agent will act as a catalyst to ease the asset transfer to and from buy side firms. Effective outsourcing of collateral settlement and substitution process to the tri-party provider reduces settlement risks, creates capacity, and should reduce scarce resources consumption.
Yet, one of the critical issues with these setups is the massive securities recall and substitution processes that can happen especially during dividend payments period (to avoid tax payments issues), and that will require operation resources to upgrade their skills and securities transfer literacy.
Finally, triparty agents closely monitor their overall liquidity risk appetite, including intraday liquidity. BONY for instance is charging intraday overdraft at the rate of 58 bp per minute of consumption. Triparty agreements will also add complexity as both parties will need to arrange to support the gross bilateral IM requirement. Buy-side firms need to be aware and seek to re-negotiate agreements with existing brokers or seeking new relationships.
IV. How can AiYO assist you in addressing such challenges?
Relying on its experience in the implementation of regulatory requirements and in conducting change management projects, combined with its cross-functional expertise on clearing area, AiYO can provide you with a pool of business analysts and senior experts with over 10 years' experience at least to help you achieve your goals.
We can help you in the adaptation or the building of systems and repositories, the design of target operating model, the definition of technical and functional specifications, the choice of a custodian and a collateral management agent, or again in the two ways IM payments process (calculation, controls, reconciliation, reporting).
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