A new trade rule to prevent another 2008 crisis is almost here – and it could blind 800 businesses
A sixth and final phase of regulation known as the Uncompensated Margin Rules will come into effect in September, and funds and trading firms are pushing to be ready. The problem is that they are not.
In two months, nearly 800 companies worldwide will be affected by the rule, more than double those of phase five, estimates the International Swaps and Derivatives Association.
Amy Caruso, head of collateral initiatives at ISDA, said unlike previous phases of the Uncompensated Margin Rule, or UMR, this final phase primarily affects fund management and similar businesses — including funds. pensions and mutual funds and small insurance companies.
The consequences of not being prepared are significant, she says. If a company is unable to calculate its margins or does not have proper custody documents and accounts, it could effectively go out of business.
“If you cross the threshold, escalating risk trading will be halted,” Caruso said. “Some of these entities may never have posted security at this point in the past.”
Both parties to the trade will need to calculate their margin requirements. If a party believes the threshold will be breached, it could prevent firms that have not prepared from trading with that counterparty.
Mandated by the Basel Committee, the uncompensated margin rule is one of many regulations born in the aftermath of the 2008 financial crisis.
At the time, major banks and corporations, including AIG, did not have enough collateral to meet the requirements after racking up a mountain of mismatched bets. The finance giants were “too big to fail” and the US government had to step in – AIG, for example, got an $85 billion bailout.
Now, any trade must post collateral before, not after, the bets turn the wrong way. These rules led to third-party buffers called clearinghouses to act as a backstop for most derivative contracts – dozens of clearinghouses sprung up after the Dodd-Frank Act and its European version EMIR. For a fee, clearinghouses effectively assume all risk should one side of a transaction default.
Since the crisis, regulators are pushing derivatives trading more on an exchange or through clearing houses to reduce the risk of contagion. But some products are too complex to clear customs. The Uncleared Margin Rule, or UMR, is a solution to limit the risk of uncleared derivatives by ensuring that these contracts have high quality collateral underlying them.
Phase six will bring firms that hold more than $8 billion in average notional value in uncleared derivative contracts into scope. These companies will then have to monitor their exposure to counterparties. If the initial margin of these contracts exceeds $50 million, the company will have to post collateral with a custodian bank.
“There are still a large number of entities that will be captured by UMR phase six that are still in the paper process or still looking for solutions,” said Eduardo Pereira, product manager overseeing UMR solutions at Bloomberg.
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State Street is one such custodian bank. Wayne Forsythe, global head of collateral management products and operations, said companies were in a “sprint” as the deadline approached.
He said he was “working very closely with clients to assess where they were in the process. There is still a lot of work to be done”.
A May Bloomberg survey of about 25 affected companies found about half were still preparing. Only 16% were ‘fully prepared’, while a third said they were not prepared at all.
Many companies want to stay below the margin threshold. Depositing margin would not only tie up assets in a deposit account, but also incur operational costs.
“It’s expensive for the business to sign up for a full collateral management process, to be able to verify the value of the margin, by looking at the reconciliation of trades and margin,” Pereira said. “There is clearly a human capital component.”
Companies wishing to stay below the threshold have two options. One: diversify their trade counterparties so that no bilateral relationship exceeds the initial margin threshold of $50 million. The other: Switch to contracts that are centrally cleared or exchange-traded.
There are signs that a growing number of companies are opting for the latter choice.
The CME said it has seen a significant increase in trading volumes of its interest-adjusted total return futures, a product intended to mimic an equity total return swap, which is normally traded over-the-counter.
“People have moved to listed futures instead of over-the-counter contracts to try to capture some of the capital savings that are on offer, or just to be more efficient in how they manage their OTC exposure” , said Tim McCourt, global head of equities. and FX products at CME.
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McCourt said he saw a 55% increase in AIR total return futures compared to last year.
Paul Houston, global head of FX products at CME, said he saw the same thing in the forex markets – around 60% of open interest is now held by buy-side participants. Before the preparation for the rules of the UMR, he saw less than 25%.
Control of uncompensated margin must be managed by both front and back office and will require continuous control.
“UMR touches every aspect of a company’s infrastructure,” Forsythe said. “It covers legal, risk and compliance. This can impact how and where clients trade.
Pension funds that operate under a “separately managed accounts” model, in which the fund outsources investment management to multiple asset managers, could face additional challenges.
To contact the author of this story with comments or news, email Jeremy Chan