The genesis of uncleared margin rules (UMR) traces back to the Global Financial Crisis, but only now are they set to directly impact buy-side institutions such as asset managers and institutional investors.

The G20 at Pittsburgh in 2009, decided to reduce systemic risk in global markets by enhancing the transparency and function of over-the-counter (OTC) derivative markets. This resulted in three things: the electronic trading of OTC derivatives, the standardization of OTC derivative products, and the introduction of swap execution facilities.

OTC derivative products with insufficient liquidity are incapable of being sent to electronic trading platforms and being centrally cleared. For these, the Basel
Committee on Banking Supervision and the International Organization of Securities Commissions (IOSCO) produced guidance imposing higher capital and margin requirements.

The multi-phase implementation period started in 2016 for institutions with more than €3 trillion of OTC products and will end with the sixth phase for those with more than €8 billion in September 2022. UMR imposes higher capital and
margin requirements for non-centrally cleared derivatives, encouraging the move to central counterparties (CCPs). 

In the first four phases, predominantly sell-side broker-dealer firms - totaling about 60 entities globally - were caught by the mandate. The fifth and sixth phases have two unique characteristics: the firms caught will surge in number to more than 1,100 firms, translating to over 9,500 counterparty relationships, and they will predominantly be buy-side entities. 

Industry dialogue

Sam Edwards, APAC head of Collateral, State Street, and Kishore Ramakrishnan, European lead, Regulatory Change practice, Vox Financial Partners, discuss the implications of phase six of UMR.

Sam Edwards: In phase six, a large number of State Street’s clients are going to be impacted. Clearly, we’re all trying to reduce systemic risk. But, as regulators put more requirements onto smaller firms, it can have the converse effect as they have to buildmany more processes and cover a lot more activity. We’re working to make sure we offer an easy one-stop shop to enable clients to outsource.In phase five, firms mixed proprietary solutions and outsourcing. In phase six, we’ll see far more firms looking to outsource to solutions such as Collateral+.Smaller firms don’t have the appetite for spending on proprietary solutions, the expertise to build them, or the people to run them. Many more clients are coming to us for UMR services. Kishore, is that a fair reflection of what you see from a market perspective?

Kishore Ramakrishnan: Yes, phase six is unique in several respects. It will predominantly catch smaller, buy-side firms such as asset managers, pension funds, and insurance firms. They have the advantages of learning from earlier phases and having a greater choice of industry utilities and service providers.There will be a high degree of outsourcing, not just of UMR-related obligations. They can step back and seamlessly integrate their middle and back offices with front-office trading to get a single source of truth throughout the value chain.

Sam Edwards: From a State Street perspective, we are seeing requests for collateral to be built into middle-office services. We have achieved integration, having just re-platformed our collateral management system. End-to-end integration and onboarding are going to be key. On the consulting services side, you talk to clients of all sizes and varying requirements. What factors do they consider when outsourcing?

Kishore Ramakrishnan: One trend is explicit: exposed firms, particularly asset managers, are very keen to outsource operational pain points to custodian banks.In the first wave of outsourcing, around 2000, asset managers turned to the big custodians to take over back-office functions and avoid significant capex on technology. In the second wave during the post-crisis years, asset managers needed exotic OTC derivatives for multi-asset strategies, but these were subjected to stringent regulatory scrutiny, and clients needed more sophisticated analytics and reporting, so the focus was on the middle office. They had underinvested in technology and needed to leverage custodians’ continuous investment in technology platforms.

Over the last decade, a squeeze on profits resulted in consolidation and the third wave of outsourcing. Asset managers are dispensing with outdated infrastructure and focusing on seamless front-to-back integration to provide instant, accurate and consistent data for investment insights as well as enhanced performance analytics and reporting. This is where banks will play a significant role in helping asset managers navigate UMR.

State Street’s fully integrated and interoperable platform, based on comprehensive and well-governed data management, establishes that single source of truth.The Alpha platform’s fully integrated architecture is paying dividends.

Other service providers utilize open architecture, modular operating models that allow asset managers to switch providers and add or remove middle and back-office services. This entails many service provider partnerships and layers of maintenance from the front to back office.

The one-stop shop model avoids the complexity of multiple systems and vendors, as well as siloed operational systems and infrastructure. The industry is gravitating to fully integrated solutions from large custodian banks such as State Street or big investment banks with a custody business.

Sam Edwards: We are seeing a lot more demand for our enhanced custody products, which almost reach into prime brokerage services. They enable that first layer of inventory and collateral management so firms can move between funds seamlessly.Asset managers tell us they want one point of contact – to supply one set of trade files and receive the full chain of services from middle-office services to collateral management and funding solutions. That’s our clients’ core business demand.

But clients need to ensure compliance on 1 September 2022, so that is the top priority.Market utilities provide all firms with a common platform to make calculations. However, they will still need solutions either from a one-stop shop or a mix of individual proprietary and outsourced services.

Kishore Ramakrishnan: Phase six firms can start taking steps towards regulatory compliance and operational readiness. First, they need to calculate their average aggregate notional amount (AANA) to determine whether they are caught by the €8 billion threshold. Then they need to identify all counterparty relationships, active trades, and credit exposures to select the right initial counterparties on the system. Then comes calculating initial margin (IM) and variation margin (VM). A grid-based approach can be used to calculate IM. However, as less liquid products don’t have enough data to calculate IM – the cells try to pick up data that doesn’t exist – they may need to rely on the ISDA standard IM model (SIMM).

The operational task of exchanging margin brings fresh challenges. Is it cash versus non-cash? How do you initiate settlement instructions and reports? How do you transfer margin assets? This is where a partnership with a service provider can really help.

Sam Edwards: One of the things we’ve been working on in relation to onboarding is a new user interface that helps the process and builds on the lessons learned during the first five phases.

Kishore Ramakrishnan: Clients underestimate the time required to onboard. During the earlier phases, the floodgates always opened at the last minute, so custodians became overwhelmed. As it can take a lot of time, many custodians politely declined. It’s important to learn this lesson and start the process now. Clients also overlook the requirement to comply with both home and host country regulations – it’s a double whammy.

From the other side, in the low interest rate environment, securities services providers cannot rely on core custody – they need to offer solutions across the transaction value chain to build long-term relationships.

Sam Edwards: Depending on their growth and development, collateral management is becoming increasingly important for buy-side firms. It has obviously progressed well beyond being a sell-side issue. It’s now very much becoming a feature in the buy side even if it’s hidden, for example, in treasury functions managing the complete range of financial resources. Many are there now, but it will soon become an optimization issue for all.

Kishore Ramakrishnan: Collateral is no longer a boring back-office function – it’s integrated into the front office and allows firms to generate alpha. Pre-Dodd-Frank, each business line – securities lending, repo, or OTC – was the master of its inventory.
Post-Dodd-Frank, the walls have collapsed, and consolidating inventory allows better use of assets. In a centralized architecture, the treasury is the gatekeeper that determines the best use of assets to achieve optimization.

As capital and margin requirements for bilateral portfolios are far more expensive than for centrally cleared portfolios, firms will offer products that mimic the cashflows of OTC products but can be listed and cleared by a CCP, like swap futures.

In general,buy-side firms want to minimize the demand for high-grade collateral. They are trying to realize the convergence of risk, liquidity, and collateral management through asset prioritization, transformation, and substitution.

However,optimization means different things to different stakeholders and functions.For the front office, optimization means control of collateral selection and generating alpha. Treasuries have a different viewpoint – they want to ensure adherence to collateral, liquidity, and regulatory capital requirements.

Service providers are looking to offer a differentiated service to win business and generate greater revenues. Collateral transformation services present a substantial opportunity for the sector.