Four months from now, the industry will be putting the final touches on the implementation of the fourth and penultimate phase of the initial margin (IM) requirements for non-cleared derivatives. For many participants, though, the real challenge continues to be how to meet the phase-five deadline one year later, despite an initiative by standard-setters to reduce the risk of a compliance bottleneck.

Back in March, the Basel Committee on Banking Supervision (BCBS) and the International Organization of Securities Commissions (IOSCO) announced that counterparty relationships that are above a specified derivatives notional threshold, but that fall below the €50 million IM exchange threshold, aren’t obliged to meet documentation, custodial or operational requirements.

Based on ISDA research, we know roughly 1,100 counterparties with approximately 9,500 bilateral relationships will come into scope once the derivatives notional threshold falls from €750 billion to €8 billion in September 2020. The BCBS/IOSCO statement means many of these newly in-scope relationships – about 6,000 – won’t need to have new documentation or custodial accounts in place because their IM exposure is less than €50 million and they won’t be required to exchange IM.

That’s helpful, but it’s not yet clear whether or how the guidance will be implemented by national authorities. The BCBS/IOSCO statement also doesn’t completely eliminate the compliance challenge for these smaller firms. These entities will still need to continually calculate and monitor threshold levels, implement IM calculation systems, identify in-scope transactions and run regular IM calculations.

This will create a significant ongoing burden for firms that do not pose any systemic risk, potentially prompting some to reduce their derivatives exposure well below the threshold level, limiting their ability to effectively hedge. Regulators should take the necessary steps to exclude these non-systemic firms from meeting the requirements entirely.

As such, we support the recommendation by Commodity Futures Trading Commission chairman J. Christopher Giancarlo for US regulators to unambiguously provide relief for counterparty relationships that don’t exceed the $50 million initial margin exchange threshold under US requirements. We hope this approach will be adopted globally to ensure consistent application of the rules.

By focusing on risk and readiness, there is a far better chance that those firms that will be required to exchange IM will be ready by the September 2020 compliance deadline.

ISDA has three other recommendations that we encourage policy-makers to adopt. First, physically settled FX swaps and forwards should be excluded from the €8 billion compliance threshold calculation – a recommendation that is consistent with the risk-based approach. Firms are not required to post IM on these products, but they are currently obliged to count them towards the threshold calculation. This requirement has no bearing on mitigating systemic risk – it simply increases costs for phase-five firms.

Second, IM model governance requirements that exist in several non-US jurisdictions for firms that use the ISDA Standard Initial Margin Model (ISDA SIMM) should be removed for non-dealer entities. ISDA has already established a governance and testing regime to back-test and validate ISDA SIMM assumptions, and this is shared with global regulators on an annual basis. ISDA also shares data on ISDA SIMM performance with regulators every three months. Consequently, there is no further need to require non-dealer firms to establish a redundant and costly oversight regime.

Third, regulators need to provide the appropriate regulatory relief to all legacy swap transactions that might come into scope due to contractual changes brought about by either Brexit or benchmark reform. Legacy contracts are currently not in-scope, but a material change – such as an adjustment to contracts to provide for more robust fallbacks based on risk-free rates – could alter that. These types of modification weren’t contemplated in the original rule-making process. We have enough challenges to get the industry ready – let’s not compound the problem by bringing legacy swaps into scope too.

ISDA supports the goal of reducing systemic risk. According to our research, the top 20 firms collected about $158 billion in initial margin from their counterparties at year-end 2018 (this excludes about $40 billion in inter-affiliate IM). It’s imperative that regulators work now to align the rules with the key policy objective of mitigating systemic risk in advance of the phase-five deadline. September 2020 is only 16 months away.

You may also be interested in:

ISDA Symposium® – Phase 4, Phase 5 and the Future of Initial Margin (IM) Documentation
IM Requirements, ISDA Documents & Streamlined IM Negotiation
Wednesday, June 12, 2019
New York