UMR Phase 5 will have a significant capital impact on in-scope firms’ trading performance. To address this impact, firms need to treat it as a trading risk management process and have calculation tools in their front-office trade workflow that provide transparency and control over the impact of IM. Liam Huxley, CEO and Founder and Samuel Hyman, Head of Americas at Cassini Systems,discuss the benefits of pre-trade and intra-day/end-of-day analysis and collateral optimisation as affected firms prepare for the UMR deadline next year.
UMR – Rules & Areas of Confusion
Phase 5 of the uncleared margin rules (UMR), coming into effect on September 1, 2020, will bring all firms with an average aggregate notional amount (AANA) in excess of $8 billion into scope for mandatory exchange of initial margin (IM). UMR will allow buy-side firms and their dealer counterparties to agree to a minimum USD 50 million IM exchange threshold. Below that threshold, firms will not be required to post IM.
Notably, many buy-side firms do not currently post bilateral margin; for others, collateral is posted based on a simple vanilla calculation – the dealer makes an independent amount (IA) calculation and the buy-side firm simply pays it. Currently IA amounts are relatively easy to calculate and verify. With Phase 5 of UMR coming into effect next year, two-way margining means that both parties of a trade will have to calculate both post and call amounts for initial margin. As completely new activity for most buy-side firms, posting bilateral margin comes with a significant operational burden as they will be required to call, manage and hold collateral.
Newly in-scope firms will need to enhance their collateral management systems and/or workflows in order to post and call margin into separate segregated custodian accounts. This introduces various operational overheads including setting up custodians and ensuring two-way legal agreements are in place. The amount of collateral they will be required to post could be materially significant. Depending on the type of fund and what collateral-type assets they have, it can cause a significant drag on the portfolio – or it can be a problem finding sufficient eligible collateral assets.
Variation margin (VM) – introduced under BCBS/IOSCO rules in early 2018 – also has to be exchanged on OTC bilateral trades. VM is netted, which means if a firm has one trade that is positive mark-to-market and one that is negative, the firm can effectively net that out and post only the net movement. IM does not work this way. Both sides must post and maintain the separate segregated collateral for the same portfolio.
Similarly, many firms believe that implementing the ISDA Standard Initial Margin Model (SIMM TM) model is a simple plug-and-play matter, where they press calculate and there is only one SIMM TM number for any set of trades. In fact, SIMM TM is based on underlying sensitivities, valuation models, and market data and can therefore vary between firms and between calculations.
Benefits of pre-trade IM analysis
Firms with significant derivatives books that fall into scope over the $8 billion notional exposure threshold, and are definitely posting IM – due to breaching the $50m threshold – on one or all their agreements must implement operational and overnight procedures and will undoubtedly see an impact on their funding and liquidity because of the extra collateral posted. These firms need pre-trade controls to determine whether the additional IM they must put up will influence their execution decisions.
For example, if a buy-side firm receives price quote from 3 different dealers on a swaption trade, it could have different overall net portfolios with those dealers and the margin impact will vary. If the firm has to put up $10 million to trade with dealer A, but only $2 million to trade with dealer B, even if the dealer B price is more expensive, it could still be more beneficial to trade with dealer B due to the lower margin. Firms need to determine the funding cost impact of the additional IM at pre-trade and adjust their execution quotes to understand the true best execution of each dealer.
Considering the cost of collateral is a fairly new phenomenon in the front office, or the pre-trade world, best execution is no longer just about the best price given by the dealer The ability to understand what a trade is going to cost is a fundamental part of trading in the capital markets and having that transparency pre-trade is key.
A second category of firms are potentially in scope, because they have more than $8billion of notional exposure, but they fall belowthe $50 million posting threshold. These firms do not have to initially set up operational processes, custodian arrangements and move collateral, but they do have an obligation to monitor and manage their IM levels to make sure they do not breach the $50 million threshold. Remember, however, should a firm surpass the $50 million threshold, you must achieve compliance with UMR immediately, including all necessary margin agreements with your counterparties and suitable custody arrangements for settlement.
Pre-trade controls are essential. Before executing a bilateral trade, firms need to check the IM impact on their portfolio to ensure it stays comfortably below that $50 million threshold, to ensure they do not breach it and to make sure any other portfolio or market movement will not change the IM profile on that agreement.
Intra-day and end of day controls provide deeper insight
Intra-day monitoring enables firms to keep a view on the overall portfolio and validate any movements in the IM as a result of either trading activities from different desks, unwinds or maturities. It gives a sense of the net impact each trade or unwind on the overall portfolio. Funds that are under the threshold need to perform monitoring and alerting to ensure that they stay under the threshold.
Others need to be able to get advanced notification of funding requirements. Towards the end of the trading day, an intra-day central view showing the overall IM view gives funds an advanced warning of what their counterparts are going to call the next day.
Other intra-day or end-of-day controls include ‘margin movement explanation’, attribution analysis, forecasting and IM trend analysis. Margin movement explanation analyses what is causing changes in the IM level from day to day. That could be from trading activity – either at a higher view, or an individual trade level – looking at the overall changes in the portfolio. Movements from one day to the next could also be due to changes in the risk in the market.
“Simply calculating an end-of-day IM number – the minimum regulatory requirement – is insufficient. If the goal is to reduce the cost of trading derivatives, simply calculating SIMM TM using a black-box calculation engine is a short-sighted way of looking at the problem.”
Cassini offers analytics which show the indicative causes of changes in the IM. If the IM is starting to trend up, a fund will, from a risk or treasury perspective, want to be monitoring that and understand why it is changing.
Attribution analysis shows where the capital consumption is: which trades or strategies within the overall agreement, or which portfolios are generating the actual IM requirement. Funds may find that they have a balanced book, with just a couple of directional trades that are actually creating 90 percent of the overall requirement. Attribution will help them understand that and allow them to work with those trades or that portfolio manager to manage or reduce it. Attribution can be monitored intra-day or run as an end-of-day report.
The other form of attribution that is a key risk control is looking at the potential unwind risk of the portfolio. Funds effectively look at the overall margin requirement as an impact of taking trades out of the book. If a trade is unwound or if a hedge is put on by a portfolio manager to offset some of his trades, unwind risk attribution shows whether it might cause an overall net movement in the margin on the portfolio and potentially lead to unintended consequences.
Forecasting and trend analysis look at the overall trends in average increase of IM, providing insight on where IM levels might go. This is particularly useful for those firms that are under the posting threshold and want to see what the margin impact will be as the book increases.
The UMR rule is only mandatorily applied to new trades after the go-live date. That means that over time, if firms only include new activity in their UMR agreements, they will start off with fairly low IM levels, which will then start to increase. Firms need to see when those levels become more impactful.
The other optimisation tool that people should be looking at is some form of novation analysis. The rules are only mandatory against new trades; but depending on the trades a fund is doing and the directionality of those trades, it can be beneficial to novate, or migrate existing open trades with that counterparty from the legacy Credit Support Annex (CSA) into a UMR compliant CSA, where those trades provide risk offset and therefore reduce the margin exposure. Funds should find little resistance from their counterparts to do that, because it benefits them as well if they have to post less collateral.
Looking at the opportunity beyond compliance
These analytical tools provide the transparency and the clarity into how margin is actually being used. With that information, funds can make better decisions, not only from a pre-trade perspective but also from a post-trade perspective, into how to better utilise and optimise their margin.
Simply calculating an end-of-day IM number – the minimum regulatory requirement – is insufficient. If the goal is to reduce the cost of trading derivatives, simply calculating SIMM TM using a black-box calculation engine is a short-sighted way of looking at the problem.
Most firms may not be aware that there are tools available that provide this additional level of transparency and analysis, but the advantages of margin analysis and optimisation are clear – especially when firms are looking at an eight-figure posting of capital they could otherwise be investing.
Historically, collateral has been thought of as a back-office operations process. Collateral management systems are typically workflow and processing systems, rather than calculation systems, set up to respond to requests for collateral, to agree them and then post it. There were no tools giving front or middle-office systems transparency over margin requirements or enabling funds to perform any kind of analytics on them.
UMR, with its massive impact on bilateral trade, has made this more critical. Firms should see UMR not simply as a regulatory burden but an opportunity to re-evaluate structurally how they handle margin and collateral costs as a firm.
Liam Huxley, CEO and Founder, Cassini Systems
Liam ran investment banking development groups in both the UK and the US before co-founding Syncova which developed the market leading platform for Hedge Fund portfolio margin and financing – providing calculation & optimisation for both Prime Brokers and Hedge Funds. Syncova was acquired by Advent Software in 2011. Liam then founded Cassini with a forward looking concept of providing the buy side with full modeling of all the new costs and constraints created by clearing and related regulations, to allow more efficient trading and portfolio management. He is currently CEO at Cassini Systems.
Samuel Hyman, Head of Americas, Cassini Systems
Samuel is Head of Americas, Cassini Systems. Hyman has over 15 years’ experience in the derivatives markets. He began his career at SupeDerivatives (now ICE Data Services) before moving on to a similar role at Bloomberg. Most recently, he worked in Sales Management at Nex -TriOptima (formerly ICAP). He is currently head of Americas at Cassini Systems and situated in the firms New York office.