Nov 3, 2014

As financial institutions look for clarity about what OTC products should be cleared, developing their own interpretation of the rules and then implementing the right infrastructure to monitor0 compliance, one thing is clear; there will be a population of OTC products that will remain bilateral and un-cleared. In parallel, firms need to understand the cost and infrastructure required to support the standards imposed for these un-cleared transactions.

In September 2013, the Basel Committee on Banking Supervision (BCBS) and the International Organization of Securities Commissions (IOSCO) published a framework for global standards for margin on non-centrally cleared derivatives.  The requirement to collect and post initial margin (IM) will be phased in over a four year period beginning in December 2015, while the requirement to exchange variation margin (VM) will become effective on 1 December 2015.   All non-centrally cleared trades transacted by financial firms and systemically important non-financial entities will likely be impacted.  Whilst the framework is not a regulation, it will act as a structure to provide guidance to the national regulators in implementing local regulation.  Impacted institutions should start planning now as these changes bring a number of challenges and issues and will have an impact on funding liquidity, systems and legal documentation.

Funding Liquidity Issues:

  • Directional portfolios will attract high IM requirements
  • The costs and availability of assets eligible for collateral are likely to increase due to increase in demand.  These include high quality government and central bank securities, high quality corporate bonds, high quality covered bonds, equities included in major stock indices and gold
  • As rehypothecation of collateral is permitted only under restrictive conditions such as hedging a specific derivative position, gross IM will result in higher funding requirements

Legal Documentation Issues

  • Changes to legal documentation will be required to support the new gross IM construct, including re-papering the existing ISDA 2013 Account Control Agreements

Operational and Technological Challenges

  • Daily margining will be onerous for smaller firms as they lack infrastructure and capacity
  • As a combination of standard and/or approved model based IM methodologies can be used, there will be difficulties in resolving disputes where both parties are using different models
  • The challenges in supporting a model based IM methodology may result in some firms opting for the less risk-sensitive standard approach
  • Firms may be required to support multiple collateral arrangements per counterparty as the new framework only applies to trades executed after 1 December 2015
  • Gross bilateral exchange of margin is not currently common practice.  Market participants will have business, operational and technical challenges in meeting the December 2015 deadline
    1. excludes physically settled FX and trades with central banks, sovereigns, multinational development banks, BIS and non-systemic, non-financial firms
  • Gross bilateral exchange of margin is not currently common practice. Market participants will have business, operational and technical challenges in meeting the December 2015 deadline

As highlighted above, there are numerous challenges ahead for those impacted by this new construct. Compliance with the rules will require industry collaboration and technology investment. Firms should not underestimate the amount of work required to meet the December 2015 deadline. Start planning now…