Investors are not out of the woods despite delay in OTC margin rule

Don't breathe a sigh of relief just yet.

Money managers and asset owners won't necessarily be getting a break from complying with a March 1 deadline to post mark-to-market margin on some over-the-counter derivatives.

While the Commodity Futures Trading Commission on Feb. 13 announced it would delay its enforcement of the variation margin requirement on uncleared OTC derivatives for six months until Sept. 1, that order applies to only a few market participants, mainly energy companies, sources said. Most market participants are subject to banking regulators in the U.S. and Europe, and those agencies remain on track for enforcing the rule on March 1.

“I've been getting a lot of emails and notices from clients asking about the CFTC action,” said Willa Cohen Bruckner, partner, financial services and products, at law firm Alston & Bird LLP, New York, whose firm represents money managers and hedge funds. “I've told them, "That's very nice, but it doesn't help you.'”

Molly Moore, counsel at law firm Ropes & Gray LLP, Washington, which represents money managers, endowments and foundations, said there might be some optimism among market participants that other regulators will follow the CFTC's lead, “but until we hear that they will, it's full steam ahead” on compliance.

Most market participants still will have to scramble to change thousands of credit support annexes — individual collateral agreements reached with counterparties — before March 1. And missing that deadline, sources said, could shut down their trading in swaps, futures or other derivatives until market participants are in compliance.

“If a pension fund or an asset manager can't get the paperwork finalized, they wouldn't be able to trade,” said Kevin McPartland, principal, market structure and technology, at Greenwich Associates, Stamford, Conn. “Their compliance offices wouldn't allow it. ... Billions of dollars in trades will be affected by this.”

For those who aren't ready by March 1, “we assume that their dealers won't trade until they're done,” Ms. Moore said. “That could have a major impact on the market. People use these instruments to hedge risk. Not having those could keep some (asset owners) from implementing their strategy.”

Ms. Moore said she's heard some dealers “are prioritizing their clients in favor of those who trade more and have more volume. The smaller client that might not trade as much might not be ready come March 1.”

The deadline has been set by the European Market Infrastructure Regulation, the CFTC and five U.S. banking regulators — the Federal Reserve, Federal Deposit Insurance Corp., the Office of the Comptroller of the Currency, the Federal Housing Finance Agency and the Farm Credit Administration. It's part of International Organization of Securities Commissions and Basel Committee regulations on overall margin requirements for these derivatives, for which variation margin is the first to be imposed. Requirements for initial margin, based on worst-case losses in a default, will be phased in through September 2020.

Acceptable collateral types under the regulations generally will be cash, but could also include gold or debt securities under certain conditions.

“The Europeans are under a lot of pressure to not let the March 1 date slip, and U.S. banking regulators are also under pressure not to back off,” Ms. Moore said. “Concern about market impact of the regulations might push those regulators to change, but certainly none (of the U.S. banking regulators or the EMIR) are making statements” like the CFTC.

Some of the largest participants in the derivatives markets — such as the $308 billion California Public Employees' Retirement System, Sacramento — already have met a Sept. 1 deadline for posting variation margin. Those participants, counterparties and affiliates had more than $3 trillion in average daily aggregate notional total of uncleared swaps and forwards outstanding for March through May 2016, the threshold for early adherence to the rules.

Market participants below the $3 trillion notional average were given to March 1 to comply — but many still aren't close to compliance. In a Jan. 24 letter to U.S. and EU regulators, the Securities Industry and Financial Markets Association's Asset Management Group and the Investment Adviser Association said 42 money managers responding to a survey said only 250 regulation-compliant credit support annexes had been put into place. That's 8% of the total CSAs among the 42 firms, the letter said.

Also, according to SIFMA and IAA, 39 of the 42 firms had completed 10 or fewer compliant CSAs, and of those, 28 firms had not completed any.

Why has much of the market waited until the last minute to comply? “To be fair to market participants, there have been so many changes going on beyond swaps, this has not been put as a high priority in their queues because compliance and legal (at pension funds and managers) have been focused on other changes,” said Greenwich's Mr. McPartland. “In the end, though, it leads to renegotiation with many counterparties. And then dealers are doing the same thing with hundreds of their clients. That's thousands of renegotiated CSAs that have to be done by March 1.”

Ms. Bruckner of Alston & Bird said the logistics of changing so many CSAs “takes a lot of time and resources. Banking regulators were focused on the Sept. 1 deadline (for larger bank and pension fund compliance); now it's everyone else — hedge funds, smaller pension funds, insurers. There's an enormous number of counterparties. And for international firms, you have to figure out which rules apply to what jurisdiction, then how to document the agreements and send them out to all counterparties. These (U.S.) banking rules aren't all of their rules.”

Some of Ms. Bruckner's clients who do not trade derivatives frequently have decided to hold off on such trades for three months while changing their contracts now. “There may be people who agree to comply now and still negotiate some terms after the deadline. Documents from dealers offer less margin leeway; counterparties will have to agree on that first,” she said.

The C$63 billion ($48.4 billion) Healthcare of Ontario Pension Plan, Toronto, which uses derivatives as part of its overall liability-driven investing strategy, is getting its CSAs compliant before March 1.

“We have to update our CSAs to ensure that the collateral schedule — what collateral is acceptable and at what haircut — is in compliance,” said Stephen Anderson, HOOPP vice president, equity derivatives and collateral management. “Currently the collateral we post will be acceptable under the new rules, although the haircuts for some might change slightly. We are in the process of ensuring compliance and will be ready to go for March 1.”

At NISA Investment Advisors in St. Louis, David Eichhorn, managing director, investment strategies, said his firm is in “a good position” to meet the March 1 deadline for the new regulations. “We have certainly heard concerns in the marketplace about the looming deadline,” Mr. Eichhorn said. “We don't anticipate that the new requirements will have any material impact on the way we implement our overlay engagements. NISA had the good fortune of structuring our derivatives documentation in such a way that the new margin rules require only relatively minor updates.”