Uncleared Margin Rules: Don't Let the Reprieve Go to Waste

The COVID-19 pandemic has had a significant impact on our lives and our livelihood. It has forced businesses into bankruptcy and exposed a wide range of socio-economic issues. The financial sector is not immune to the pandemic and is dealing with extreme market volatility.

Early signals of financial stress were received in late March when a leading Dutch bank group announced that it marked losses in the millions due to a failed margin call. The Basel Committee on Banking Supervision quickly acknowledged the disruption and published guidance to delay phases 5 and 6 of the Uncleared Margin Rules (UMR) each by a year. This increased market volatility, and the relief from regulators has unique implications for financial institutions that require them to re-calibrate their UMR compliance efforts.

Margin Calls and Collateral

The first impact of increased volatility is the higher initial margin requirement. Initial margin is required to provide coverage for potential future exposure of uncleared derivatives over 10 days at a 99% confidence level. Increased volatility results in a higher potential exposure in the future, and thus a higher margin requirement.

A recent report from AcadiaSoft indicated a 60% jump in the average margin call amount (however, it includes both the initial and variation margin). This directly translates to the need for more collateral.

The second impact is on operations. Margin is exchanged only if the exposure is above a mutually negotiated threshold. With both greater volatility and exposure, there is an increased likelihood of the threshold being breached.

As AcadiaSoft reported, there were 75% more margin calls in March, and 25% more in April, compared to those in January and February. For the trading counterparties, this creates stress on operations teams and a greater likelihood of operational errors.

Added Documentation

To understand the third impact, we need to look at the clarification provided by the Commodity Futures Trading Commission (CFTC) back in July 2019.

Compliance with uncleared margin rules requires complex documentation between the two counterparties, as well as between counterparties and their respective custodians. As per the CFTC”s clarification, this documentation is not necessary if the initial margin requirement between the two counterparties does not exceed the $50 million threshold. However, the CFTC had to set up processes to monitor their initial margin, so that they can start negotiations and do paperwork once their initial margin requirement approached the regulatory threshold.

With increased volatility, counterparties are likely to hit the threshold sooner than they might have anticipated pre-COVID. This requires them to undertake the contract negotiations and related paperwork sooner.

More Time to Optimize

Before the one-year delay of phase 5 was announced, preparations for UMR compliance were well underway with most counterparties. While the extension of the deadline disrupts these preparations, it also gives counterparties more time to evaluate their options.

If the counterparties had not already signed up with a collateral administration partner, or decided if they were going to build it in-house, we believe they will take the time to review the various offerings in the market before locking in their final compliance approach.

Those counterparties that are close to the $50 million regulatory threshold are likely to also explore ways to stay below this threshold. They could do this by clearing more trades, compressing trades, or using alternate trading strategies.

The Way Forward

If there is one thing that earlier phases of UMR have taught the industry, it is that it's never too early to start preparing. The additional time provided by regulators is easily offset by the need to deal with the increased complexity discussed above and the loss of productivity that was caused by COVID.

To address the need for greater collateral, counterparties should consider building a consolidated inventory of their collateralizable assets and implement an optimization algorithm to ensure efficient use of those assets.

The spike in the number of margin calls and corresponding stress on operations can be mitigated by automation. Many large institutions still see over half of their clients negotiate margin calls over email instead of electronic messaging. Advancements in natural language processing offer innovative solutions that can automate the email workflow to a large extent and assist in a faster investigation of margin call disputes.

Finally, the increased workload of negotiation and paperwork, calls for implementing a robust contract lifecycle management system.

In summary, volatility in the market will require counterparties to exchange more collateral, deal with more margin calls, and force them to negotiate documentation early. The extension provided by regulators will be counterbalanced by the need to mitigate this complexity.

Counterparties are also expected to leverage this additional time to shop around for more economical solutions and explore ways to stay under the regulatory threshold. Collateral service providers, on the other hand, will see more competition and would be expected to offer more compelling propositions to win new business.

Vivek Agarwal (vivek.agarwal7@wipro.com) is a partner in Wipro's Securities and Capital Market Consulting Group. In his consulting career, he has led marquee programs at top Wall Street firms and conceptualized several business solutions leveraging data and artificial intelligence. He is currently advising a global custodian on uncleared margin reform.