If there’s one lesson from the most recent round of initial margin (IM) requirements in September 2021, it’s that compliance takes much longer than most people anticipate. With the next phase now less than six months away – one that will bring more entities into scope than ever before – it’s critical this lesson is learned. The reality is there’s very little time left to comply. Those firms that wait to start their preparations may well find they face difficulties trading from September 1.
Phase six will bring an estimated 775 entities into scope of the IM requirements, more than double the number caught by phase five in 2021. That was enough to cause some bottlenecks and delays, with lengthy custodian onboarding processes, the sheer volume of credit support documentation and custodial agreement negotiation and extensive know-your-customer requirements putting pressure on compliance timetables.
The upshot was that many phase-five entities were unable to complete the necessary steps with all their trading partners in time, causing them to focus trading activity with those relationships that were operationally ready or stick within the limits of their IM thresholds (ie, less than €50 million in IM exposure per counterparty group). Together, that meant there was no significant market disruption on September 1, 2021.
But it’s by no means certain that phase six will run as smoothly, because the challenges faced during phase five will be exponentially greater this time round. The estimated 775 in-scope entities translate into roughly 5,400 counterparty relationships, putting a huge strain on the ability of firms to complete document negotiation and custodian onboarding processes in time. The entities caught by phase six also have fewer resources available to them than the bigger institutions captured by earlier phases, as well as less extensive automation of margin processes.
An added complication is the fact that many of the pension funds and investment companies caught by phase six have their derivatives portfolios managed by multiple asset managers through separately managed accounts. This means preparations are reliant on each entity calculating its swaps exposures across all its separately managed accounts and disclosing to its asset managers if it expects to breach the threshold for compliance. If these calculations and disclosures are submitted late, the asset managers cannot begin preparations, leading to delays.
On the plus side, a large share of counterparty relationships under phase six is unlikely to breach the €50 million IM threshold – ISDA estimates that proportion could be between 78% and 85%, depending on the methodology used to calculate IM. As well as not having to exchange collateral with those counterparties, regulators have stated that documentation, custodial and operational requirements for each relationship also won’t apply until the threshold is breached.
That doesn’t mean firms can afford not to act. As a first, immediate step, all potentially affected entities must calculate on an indicative basis whether they exceed €8 billion in aggregate average notional amount (AANA) of non-cleared derivatives – the threshold for compliance – and notify their asset managers and counterparties if they may be in scope. The official three-month calculation period began on March 1 under most regulatory regimes, meaning in-scope entities will have to notify counterparties of their final status in May.
There are a variety of ways to do this, including an ISDA initial margin self-disclosure letter that can either be sent to counterparties bilaterally or electronically via ISDA Amend to other ISDA Amend participants.
Those entities that expect to exceed the €50 million IM threshold with some or all of their counterparties would then need to appoint a custodian to meet IM segregation requirements and begin the onboarding process – something that can take several months. They also need to start negotiating regulatory-compliant credit support documentation with each counterparty, develop, test and implement a margin calculation model, and establish processes for managing the exchange of collateral.
Even those entities that don’t expect to surpass the IM threshold will need to closely monitor their exposures with each counterparty and be in a position to move quickly to meet documentation and custodial requirements if the €50 million level is close to being breached with any trading partner. That will require the setting up of a framework to calculate and monitor IM on an ongoing basis.
Fortunately, a number of industry tools have been developed for earlier phases, which can help firms with their compliance efforts. These include the ISDA Standard Initial Margin Model – an industry-wide tool that eliminates the need for each firm to develop its own margin calculation methodology, cutting down on the potential for disputes. Firms can also use the ISDA Create online platform to negotiate regulatory-compliant credit support documentation and certain custodians’ account control agreements, bringing much greater efficiency to the process. Alongside ISDA’s standard documentation, eligible collateral templates and the Margin InfoHub, market participants have all the raw ingredients for compliance.
But none of that means anything if firms don’t realize they are in scope or assume they can wait until July or August before they focus on compliance. This really is the last chance for in-scope entities to get the ball rolling on implementation. Those that don’t may face a nasty surprise come September 1.
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