The non-cleared Initial Margin rules have accomplished their objective to reduce the size of the non-cleared derivatives market by creating an incentive to centrally clear more trades as opposed to margining them bi-laterally.
At the half-way point into the implementation of the non-cleared margin rules, it seems like a good time to pause and reflect on what went right, what went wrong, how the next few years might be different and maybe even more importantly, whether regulatory policy has been effective.
SIMM – Where Would We Be Without It?
The industry owes a great deal of thanks to the ISDA Working Group for Margin Reform, for without a common model that both counterparties can use to validate each others margin calls, collateral chaos would have ensued. The early days after September 1st, 2016 were still challenging times for the 26 counterparty groups that went live under the rules. Until firms could expand the number of active Initial Margin (IM) Credit Support Annex (CSA) and tri-party agreements, trading volumes were depressed. However, volumes quickly picked up as firms moved to finalize new legal agreements, and investments in market infrastructure began to pay dividends.
Documentation Challenge Preview
Ahead of the September 1, 2016 go-live date, many IM CSAs and tri-party agreements had to be negotiated. Along with those new agreements came the enormous operational challenges associated with the redocumentation effort. Thus, the industry got an early glimpse of just how difficult the March 2017 Variation Margin (VM) Big Bang would be. Firms worried that it took too long to negotiate an IM CSA or tri-party agreement. Then once the agreement was finalized, it took even longer for firms to set up the agreements in their internal systems.
IM Phase 2
The IM Phase 2 go-live was much more organized than IM Phase 1. With fewer firms in-scope (6 counterparty groups), Phase 2 firms had more time to test and negotiate agreements, which resulted in fewer margin differences with their counterparties on day 1. Phase 2 firms were therefore much more prepared to go-live exchanging two-way IM than their Phase 1 peers. But IM Phase 2 firms still looked largely like the Phase 1 firms from an implementation perspective – they all had large project teams and resources to attack the compliance challenge.
However – drawing on our experience in working with all Phase 1 and 2 firms in-scope for the IM requirement – AcadiaSoft expects that the IM experience of Phase 3, 4 and 5 firms will be different than that of firms from the earlier phases. Phase 3, 4 and 5 firms lack the big budgets of their predecessors in prior phases, leaving them with greater compliance and technology challenges. Moreover, Phase 5 will see large numbers of buy-side firms included in the requirement for the first time. These firms will need a broader set of services including a simple and inexpensive means to connect to market infrastructures that provide options to pick and choose how they want to comply with the rules, based on their operational preferences.
Supporting the Industry
AcadiaSoft is evolving to support the needs of IM Phase 3, 4 and 5 firms by becoming a one-stop-shop for Initial Margin. Are you at a firm that wants to use SIMM but lacks the required technical resources? Send us your trades and well calculate the sensitivities for you, map your risk to standard SIMM buckets and calculate your IM. Do you want to move from your current spreadsheet-based collateral management system (because your margin call volume is going to double or triple) to one that is inexpensive, functionally-rich, easy to implement AND is already connected to the key industry utilities such as our own AcadiaSoft MarginSphere and DTCCs Margin Transit Utility (MTU)? We can make it happen. Need a back-testing and benchmarking solution but you dont have the quants or the budget to do it yourself? We can help.
Whats Next – Unfinished Regulatory Business?
This reflection would not be complete without considering some broader policy questions. Namely, have the non-cleared rules accomplished their objectives to reduce the size of the non-cleared market by creating an incentive to centrally clear more trades as opposed to margining them bi-laterally? Based on the latest industry stats published by ISDA which track year-over-year interest rate and credit cleared derivatives volumes, the answer is yes. Year-over-year cleared Interest Rate Derivative (IRD) and Credit Default Swap (CDS) trade volumes are up 22% and 27% respectively as of April 2018, while uncleared IRD volumes are up only slightly year-over-year (7%) and CDS volumes are down (-13%).
What of the regulatory goal to reduce systemic risk? Certainly, by requiring two-way IM posting that is segregated at an independent 3rd party, regulators have succeeded in shifting the industry risk framework to a defaulter pays model. And if two key regulatory initiatives have already been accomplished, one could ask: does it make sense to eliminate or at least raise the IM Phase 5 gross notional threshold from $8 BN to something more reasonable? I will explore the idea of raising the Phase 5 threshold in the next few paragraphs.
Trouble on the Horizon?
Looking ahead to the remaining two-and-a half-years on the IM phase- in requirement, we at AcadiaSoft see an additional 10 to 12 Phase 3 counterparty groups in scope for September 2018. These firms will also mirror IM Phase 1 and 2 firms in that they are mostly prudentially- regulated regional banks. In IM Phase 4, we see approximately 50 to 80 counterparty groups which will generally be prudentially-regulated regional banks; however, there will be a small population of buy-side firms included in this phase.
The entrance of the buy-side in full force for IM Phase 5 is where things get interesting. At present, the IM Phase 5 gross notional threshold is set at US $8 BN (or the rough US $$ equivalent in other regulatory regimes around the world). AcadiaSoft expects approximately 1,500 to 2,500 additional firms to fall under the requirement.
E – estimated
IM Exposure by Phase
The total amount of regulatory IM exposure that is attributable to IM Phase 1 as of March 31, 2018 (from a collect perspective) sums to $101 BN. However, the incremental amount of IM exposure attributable to IM Phase 2 firms drops significantly, to $4 BN as of the same period. Extending this trend forward for the next couple of years and making some assumptions around IM Phases 3, 4 and 5, AcadiaSoft estimates that IM Phase 3 and 4 firms will collect IM of approximately $3 BN and $2 BN respectively. However, given the uncertainty regarding the uncleared swaps activity of IM Phase 5 firms – estimating IM exposure gets far trickier.
The question becomes how much of the cumulative IM exposure from Phases 1 through 4 represents inter-dealer proprietary trading versus IM exposure generated because of inter-dealer trades that are hedging a buy-side trade. For example, if 10% of all trading between IM Phase 1 through 4 firms is proprietary trading – that leaves 90% of year 1 through 4 cumulative IM exposure attributed to hedging buy-side trades.
Also, based on preliminary feedback, if IM Phase 1 through 4 dealers successfully negotiate a $0 IM collect threshold on 80% of their phase 5 relationships (even though the regulations permit up to a maximum $50 MM IM threshold) while retaining a $50 MM posting threshold for themselves in all but 20% of their Phase 5 relationships, AcadiaSoft estimates that Phase 5 IM exposure could grow by an additional $120 BN on a net basis: Phase 1 through 4 firms would collect an additional $99 BN of regulatory IM from phase 5 firms while Phase 5 firms could collect an additional $21 BN from Phase 1 through 4 firms.
ISDAs latest annual survey data indicates that IM Phase 1 firms have already collected over $57 BN in discretionary (or non-regulatory) IM. If the bulk of this number is posted by smaller buy-side firms to the larger dealer population – and considering the CFTCs IM segregation rule which in 2014 required swap dealers and major swap market participants to annually notify their counterparties of their right to request that any initial margin that they post be segregated at an independent third party – one question market participants should be asking themselves and their regulators is: what is the appropriate level for the IM Phase 5 gross notional threshold? Is there a Phase 5 threshold number that industry participants and regulators could agree on that would capture 80% of the Phase 5 exposure while only affecting 20% of the existing Phase 5 in-scope firms?
ISDA and the industry must quickly work together to do this analysis and make their arguments before time runs out.
Mark Demo is Product Director for AcadiaSoft, Inc.
