BY RAVI SONECHA
In the face of unprecedented regulatory reform, the over-the-counter (OTC) derivatives market is straining to adapt to new clearing, transparency and margin standards. Undoubtedly the importance of standardisation across industry participants, processes, and documentation is increasing with every new rule. The updated margin standards for OTC derivatives offer the chance for market participants to revise and normalise existing collateral agreement practices to not only meet regulatory requirements, but also leverage the opportunities that they present.
Margin Exchange – How did we get here?
The financial crash of 2008 exposed significant weaknesses in the resiliency of banks and financial market infrastructure. Over-The-Counter (OTC) derivatives were revealed as a critical component of the crash, and the industry agreed that improved transparency and increased regulation were required to reduce the excessive risk-taking and systematic risk posed by OTC derivatives transactions, markets, and practices.
In 2009, the industry mandated the use of centralised clearing for standardised derivatives trades and were successful in driving over 60% of all derivative contracts through central counterparties. As a secondary measure to the remaining 30%+ of uncleared OTC derivative trades, the Basel Committee on Banking Supervision (BCBS) and International Organisation of Securities Commissions (IOSCO) in 2013 published a framework that identified global minimum margin standards.
This framework imposed the following key changes:
- The mandatory exchange of Variation Margin (VM) and two-way exchange of gross Initial Margin (IM), which must be calculated using standardised or approved models
- The restriction of eligible collateral to only highly liquid assets
- The holding of collateral such that margin is immediately available to the collecting party in the event of default
- The settlement of collateral within one business day following collateral calculation (or two if there is no requirement to collect IM)
These requirements had two main aims:
- Reduction of systemic risk by ensuring that collateral is available to offset losses caused by the default of a derivatives counterparty
- Promotion of central clearing by increasing the previously attractive low margin cost of uncleared derivatives
VM Rules – The Industry Delay
The BCBS-IOSCO framework applies globally but is being executed in phases by local regulators. On 1st September 2016, the IM rules came into force for the highest volume swap dealers and major swap participants.
VM rules were due to be enforced for all impacted parties on 1st March 2017, however regulators provided last minute relief for counterparties without “significant exposure” to uncleared OTC derivatives. This was largely due to the volume of outstanding collateral agreements that still required revision to be compliant with the updated margin rules. Without this contract in place, parties cannot legally trade OTC derivatives. With 4 weeks to go before the 1st March deadline, only 10% of the required collateral agreements had been successfully repapered.
A collateral agreement (e.g. Credit Support Annex) specifies the type of collateral that can be exchanged between counterparties when calling for margin. As these are negotiated bilaterally, contracts can vary from party to party. This causes issues for banks and market participants as two identical trades can have different valuations depending on the terms of the collateral agreement. Contracts that allow securities to be exchanged as VM can add to a bank’s leverage ratio, and agreements that permit both cash and security margin exchange can be penalised by the Net Stable Funding Ratio.
Why was the Industry Challenged?
In meeting the VM regulatory requirements, the industry had the opportunity to not only satisfy their supervisory obligations, but also reap the benefits of standardised and streamlined collateral documentation.
A number of market participants failed to capitalise on this opportunity for three main reasons:
- Industry Underestimation – It is likely that the primary reason for both the VM regulatory relief and non-standardisation of collateral documentation is because industry participants underestimated the time, effort and skill-set required to comply with the new requirements. Some of the largest banks had to remediate tens of thousands of agreements; some buy-side firms were not aware that they were even captured by the rules.
- Rigid Industry Protocol – Market participants assumed that up to 60% of collateral agreement remediation would occur through ISDA’s Variation Margin Protocol, which was developed to help participants convert existing agreements to achieve compliance. Although sophisticated, the tool did not provide the necessary flexibility to accommodate the varying collateral requirements of different counterparties. This meant additional and unforeseen bilateral negotiation between parties, which often take weeks to finalise.
- Buy-side pushback – The final reason is likely due to an unaligned buy- and sell-side. Whilst the sell-side strived to move from bespoke multi-collateral agreements to simpler, cash-collateral-only agreements, the buy-side pushed back citing inaccessibility to large sums of cash and immaterial balance-sheet benefits. This, in addition to concerns of a bifurcated portfolio trading on both legacy and newly-negotiated contracts, led to elongated negotiations and ultimately concession from the banks as deadlines approached.
Industry Lessons and the Path Forward
For those carrying “significant exposure” to uncleared OTC derivatives, it has been a week since the implementation of the VM regulatory rules and many market participants will be bruised and battered following their compliance efforts. It’s clear that meeting regulatory requirements will be an ongoing journey.
In the short-term, firms should make best efforts to normalise their negotiation approach for any outstanding collateral agreements, such as the use of standardised language with the majority of counterparties. This will inevitably accelerate their remediation process. A reprioritisation of counterparty consultation may also be advisable to ensure that those with the largest exposures are identified and remediated.
Longer term, given the events leading up to the implementation of the VM regulatory rules, it is critical for any future execution of global standards that the industry a) evaluates requisite efforts, b) coordinates with and iterates industry tools designed ease compliance, and c) defines an agreed and scalable approach to manage large-scale change.
It is likely that standardised collateral agreements between financial market participants will be achievable as the OTC derivatives industry develops. The driver may be additional regulatory reform, introduction of an industry utility requiring standardised agreements, improved industry protocol, industry innovation, or cost reduction and simplification, however developing a harmonised, structured, and scalable approach to collateral agreement negotiation will provide the necessary platform to do so.