The recent extension to uncleared margin rules (Phase V) should in no way lull asset managers into a false sense of security. Since IOSCO and the Basel Committee confirmed the extension, which forces firms above a certain aggregate average notional amount (AANA) to exchange initial margin (IM) on uncleared derivatives, many firms might be thinking one of two things: that they’ve either got plenty of time or plenty of resources to tackle the rules. Yet, the reality is they have neither.
The one-year extension has created confusion around who should be preparing for the final phase and, crucially, when. Even more worryingly however, is the deep uncertainty centred around how to prepare for the new rules effectively, whether it’s required in one year or two.
Like many regulations, there are elements of UMR that are being both misunderstood and underestimated. In particular, are the new complexities around reconciliation requirements and the level of preparation needed from firms to resolve them. ‘Trade reconciliation’ refers to a set of post-trade activities that identify a mismatch between what two counterparties consider the core value of the instrument. Once upon a time, firms were only required to reconcile four to five different parameters of the trade – but this is all set to change. These new requirements will make reconciliation significantly more complicated and cause huge disruptions for any unprepared parties trying to implement it.
In other words, firms will have to agree what the risk sensitivities are of each trade, which means modelling each instrument independently under consistent assumptions. It might seem simple, but a number of questions have to be answered: what market data source should be used? Which risk bucket should the security fall in? How should the curves be constructed? Asking the right questions comes with its own complexities – some instruments were originally created for bilateral agreement, making historical data for modelling difficult to find and the risk sensitivities even more difficult to calculate.
Without the right foresight, planning and technology the two counterparties attempting to trade could calculate two different risk profiles and end up in dispute. If a dispute is not resolved, firms may be posting too much margin which can tie up more capital and affect returns. And while this can be critical for hedge funds, asset managers have a surplus of bonds which they can post as margin instead, meaning this implication of getting reconciliation under UMR wrong can be a hassle, but not a disaster.
Instead, the challenge for asset managers finding themselves in dispute will largely be around resourcing. If reconciliation is not carried out accurately, the next step for asset managers will be to pull in quants (quantitative analysts; experts on risk and pricing) to solve it. However, the issue with allocating return-generating employees to day-to-day reconciliation, is that significantly less time is being spent on profitable front office activities. Meaning, what on first glance might seem like a simple resourcing issue, quickly becomes a returns one as well.
And while the returns and resourcing issues need to be addressed, an even more sinister impact of UMR is just around the corner: regulatory repercussions. Currently there is minimal data for phase I – III firms on noncompliance with UMR as almost every firm complied. Available data does show that where AANA was borderline firms did get permission to move forward by another year based on a best effort basis. But, in an extreme scenario, a firm may be prohibited from making any new cleared and in-scope trades.
Ultimately, when it comes to firms posting initial margin and understanding how to do it correctly, you might think it was clear as to what should come first. Instead, the reality is that asset managers are only truly understanding the complexities of posting margin, after they’ve been made to post it. Firms need to take control now or risk stumbling through the process later.
The false sense of security can only last so long, when reality hits asset managers could find themselves out of time, resources and ultimately struggling with returns.
Veeral Manek is Head of Product Specialist at OpenGamma
