It's near zero hour to meet new margin rules

The final phase in an onerous global regulatory initiative that will require more institutional investors to post collateral for their over-the-counter derivatives transactions will go into effect in September in the U.S., and some of the largest pension funds and asset managers might not be prepared for it, sources said.

"The message we're giving to our clients is if you're subject, you should have been ready already," said Ram Kelkar, Chicago-based principal and managing director of the capital markets group at Milliman Inc. "There is no time left. If you're subject, you need to be acting right now."

Institutions or money managers with more than $8 billion in cumulative uncleared derivatives exposure as defined in the rules will soon be subject to regulations borne out of the 2008 financial crisis. Mr. Kelkar and others are urging clients to assess — and then prepare — if they're governed under the new rules.

In 2015, the Commodity Futures Trading Commission and U.S. banking regulators adopted final rules to implement the Basel Committee on Banking Supervision and the International Organization of Securities Commissions' uncleared margin rules, or UMR. Those rules established requirements for variation margin and initial margin for over-the-counter derivatives not cleared through a central counterparty.

Since 2016, UMR has been phased in, gradually bringing more firms under its requirements. Come Sept. 1, the final phase — phase 6 — will go into effect, lowering the average aggregate notional amount threshold under the regulations to $8 billion from $50 billion.

For such parties, they will have to post and receive initial margin, in which a percentage of an uncleared derivative’s value is put up as collateral. 

Before UMR, long-term investors, such as pension funds, typically wouldn’t have to post initial margin because their risk profiles are conservative, said Michele Navazio, a New York-based partner in Seward & Kissel LLP’s corporate finance group and chairman of the firm’s derivatives and trading practice group. But under UMR, both counterparties in a transaction, including banks, must post initial margin. 

“The whole idea is to try to mitigate systemic risk by ensuring that every party to a derivatives contract is as protected as possible,” Mr. Navazio said.

Typically, pension funds use derivatives as risk-hedging instruments and not to make speculative bets.

Mr. Kelkar said the new regulation is onerous and will require “a huge amount of time and money” for parties under scope. “I believe derivatives can be used to reduce risks, which is what pensions and insurance companies should be doing, not speculating, and all that this does is makes it harder for them to reduce risk,” he said.

UMR applies to derivatives that are unsuitable for clearing at central exchanges, including interest rate swaps, currency swaps, equity swaps, forwards and options. The rules apply to pension funds, insurers, hedge funds, asset managers and other financial institutions.

The initial margin exchanged between the counterparties, which can be in the form of Treasury or other agreed upon assets, needs to be stored in a segregated account structure with traditional custodians or tri-party agents, noted Bob Stewart, Boston-based executive director of institutional trade processing at the Depository Trust & Clearing Corp., a U.S. clearing and settlement service provider. The initial margin cannot be touched unless one party defaults.

Institutions need to first figure out whether they’re under scope for phase 6 and can do so by calculating their average aggregate notional amount, or AANA, of uncleared derivatives.

“If a firm is in scope for UMR phase 6, the industry recommendation is to start preparing in March, April, May,” Mr. Stewart said. “I’ve been telling in-scope clients, ‘Don’t wait to March, April and May, start now. Start preparing as soon as possible.’”

Staffan Ahlner, London-based global head of Collateral+, a part of the funding and collateral solutions group at State Street Corp., is urging institutions to seek a one-time AANA calculation and work with their service providers immediately if they’re under scope.

“The last thing we want is a client coming up in late August saying they’re under scope and they can’t meet their regulatory obligation,” Mr. Ahlner said.

State Street launched Collateral+ in March 2021 to help buy-side firms manage collateral obligations under UMR. Collateral+ has a March 31 deadline for firms to utilize its services because the preparation process is lengthy, Mr. Ahlner said.

“We’re urging our pension funds and asset managers to make sure that they’re covered, make sure that they have a plan around this,” he added. “And equally, they need to make sure that the asset owner and asset manager have a clear responsibility who is solving this for the fund.”

John Pucciarelli, New York-based head of industry and regulatory strategy at Acadia Inc., which offers risk management products for the derivatives industry, made a similar point.

“If you just start the process in May, custodians are already working on this with other clients,” Mr. Pucciarelli said. “Depending on where they are you’re going to be placed in a queue, so it could be days, it could be weeks before they get to you.”

Importantly, institutions under UMR must exchange initial margin only on uncleared derivative transactions executed after Sept. 1 and only when initial margin exposure exceeds $50 million with a specific counterparty. If the initial margin does not exceed $50 million, the two parties do not have to exchange anything. 

It’s vital for institutions under UMR rules to closely monitor trading activity with all counterparties, Mr. Pucciarelli said, noting Acadia offers a threshold monitoring service. “You do need some kind of an early warning system because you cannot breach it and then try to trade the next day, or you’ll be put on the do-not-trade list by the dealer,” he added.

DTCC’s Mr. Stewart said: “If you’re in scope, you really have to manage your counterparty relationships. Perhaps with some you will need to exchange collateral, but with others, you won’t, but you will still need to monitor it.”

To figure out how much initial margin needs to be posted, firms that exceed the $8 billion threshold can use the International Swaps and Derivatives Association’s standard initial margin model, known as SIMM. Many firms outsource the calculation, Milliman’s Mr. Kelkar said.

As institutions prepare for the Sept. 1 phase 6 deadline, time is of the essence. “Even if you don’t have a direct trading relationship with your traders, you should at least call your asset managers and work out how we all look together,” Mr. Pucciarelli said. “If I have separately managed accounts, what does this look like for us? And who’s owning the project management? Who’s going to calculate SIMM? All of those things should probably be done right now. There should be a sense of urgency. For pension funds who haven’t been very close to this, I would say, ‘Get closer. Get as close as you can to it now.’”