Variation and Initial Margin Collateral Management - A new challenge

1 September 2022 marked the introduction of the final phase of Uncleared Margin Rules (UMR). This has been a very long process which has included 6 phases and has gradually caused a large number of market participants to post variation and initial margin to support their derivative trading. It is worth noting that UMR only applies to new trades after the date of implementation.

In the case of variation margin (VM), most jurisdictions require ‘financial counterparties’ to exchange VM while generally allowing end users an exemption.

For initial margin (IM), if the Average Aggregated Notional Amount (AANA, which is basically the gross notional of all uncleared derivatives including FX) exceeds a specific amount at each phase, then both counterparties are obliged to post IM for their uncleared non-FX derivatives if they are both ‘covered entities’ (i.e., have exceeded the AANA at any phase).

The implementation calendar is as follows:

Why is VM and IM collateral a challenge?

VM has been used for many years prior to 2017 as a credit mitigant to offset the mark-to-market (MTM) of a derivative with a counterparty. VM can be posted or received depending on the MTM.

IM is posted by both counterparties to independent custodians. It does not depend on the MTM, but rather on the risk of the derivatives. It is seen as insurance against future movements in MTM.

Changes to capital calculations for many banks (Basel I, II and III) have also contributed to the use of VM and IM. Where banks use collateral, they can reduce the capital drag on derivatives substantially, making them more competitive and increasing returns. This impact can also change the pricing of derivatives for end users as banks using lower capital can effectively ‘pass on’ the savings.

While IM Phases 1 – 4 had their own issues, the firms involved had significant resources and experience in managing and providing IM with each other for uncleared exposures and with CCPs for their cleared trades. The problems for these firms were often associated with engaging the independent custodian and setting up separate accounts. For example, in Phase 1 there were approximately 10 firms but they each required thousands of individual accounts at custodians to support the legal entities! All this took time and effort.

As we moved to Phases 5 and 6, the firms captured by the regulations are often less familiar with the operational requirements of posting IM and managing the complexities of posting and receiving VM. They also, like the previous phases, needed to set up custodian relationships and open accounts as necessary.

The number of Phase 5 and 6 counterparties is estimated at 1,200 in total which far exceeds the previous 4 phases (~100 in total). When the significant number of new firms and the probable level of experience of those firms is combined, there are challenges for all participants as there are 2 sides to every transaction with individual and joint responsibilities.

If there is a mismatch in capability and experience between the counterparties, there can be ongoing challenges for both counterparties in both VM and IM.

Challenge 1 – Agreeing and reconciling IM and VM

All regulatory jurisdictions require counterparties to agree the IM and VM amounts daily within quite tight tolerances. If the counterparties cannot agree, then a process of reconciliation commences.

This generally starts with checking the actual portfolio (number of trades) followed by valuations of individual trades (VM) and risk inputs to IM calculations. These activities can be complex, detailed and time-consuming. In many cases, sophisticated quantitative tools are required which may not be readily available to both counterparties. We have found that Phase 5 and 6 firms in particular do not have these tools and processes established and ready to deploy.

With short timelines for reconciliation, some clients are having problems achieving the short turnarounds required for resolving IM and VM differences.

Challenge 2 – Availability of acceptable collateral

Most firms who post or receive VM collateral have reviewed their documentation and restricted the options for that collateral to currencies and/or securities they can access for posting and accept when receiving. For smaller firms, this is often cash in their domestic currency as they have limited availability of foreign cash for posting and limited ability to accept and invest a foreign currency.

Although USD is the standard collateral currency, we have found many smaller, buy-side firms will require their domestic currency as VM. This does solve the operational problem but can create other complexities such as that in Challenge 4.

IM has a very different collection of potential issues. The generally preferred IM collateral is limited to certain types of securities (e.g., government bonds) which are agreed between counterparties and can be accepted by their respective custodians.

Larger firms (banks) can routinely access these securities either directly from their own accounts or via repo markets. Either way, they have established and efficient processes to find and post the required IM collateral.

Smaller firms typically do not enjoy the same access to these securities, especially investors who own other securities aligned with their investment mandates and return metrics. Cash is not preferred by custodians, and they will charge large fees for accepting cash as IM due to regulatory costs. Repo is available but firms still need cash collateral for the repo and the systems and processes to trade and settle the repo. Again, this is very costly and inefficient for smaller firms.

We have found that smaller firms have often had problems accessing and managing collateral especially for IM.

Challenge 3 – Balancing fund returns for investment firms

Investment firms have an additional set of challenges that arise from the multiple funds, legal entities and fiduciary duties associated with those funds.

Many firms need to maintain separation between the funds and accurately record and price collateral borrowed from one fund to post for another fund. This is fast becoming and issue for Phases 5 and 6 firms as they begin to post IM created by derivatives in one fund, but they borrow the securities from another fund. This has to be priced at arms-length and accurate records and accounting entries posted to maintain the integrity of each fund return.

Challenge 4 – Pricing and revaluation

USD collateral is the standard for pricing derivatives and the published prices are assumed to be using this standard. For example, a USD interest rate swap uses USD SOFR as the default collateral as does a USD/JPY or USD/AUD cross-currency swap. In the case of other currencies, the collateral is assumed to be the domestic currency, for example AUD interest rate swaps use AONIA as the assumed collateral return rate.

As outlined in Challenge 2, many smaller firms prefer their domestic currency. In the cross-currency example, many buy-side firms have VM in JPY or AUD depending on their location.

When you change the collateral currency assumption, this can (and often does) have an impact on the price of the derivative. In some cases this difference is small and can be effectively ignored. But in other cases (e.g., cross-currency) the impact can be significant and can change the price.

All firms need to be able to price this difference: either they are charged for it or they need to demand the better price. Otherwise, a sophisticated, unscrupulous counterparty may simply ‘trouser’ the profit and the less aware firm will never notice the difference.

So, what you see on the screen as the price of a derivative for a new trade or a revaluation rate may need to be adjusted for your collateral currency if it is not USD or the assumed domestic currency for that derivative.

Revaluation rates are also problematic for many firms as they must adjust the rate from a screen or valuation service to reflect their collateral arrangements per counterparty. This is very complex and can seriously impact both accounting and the ability to reconcile VM and IM with a counterparty.

Challenge 5 – Back testing the portfolio

Firms included in all IM phases in most jurisdictions are require accreditation by their local, and occasionally offshore, regulatory authority. One of the more difficult and ongoing challenges for many firms is demonstrating appropriate back testing of the portfolio to show the IM posted is adequate to cover the risk of default.

Banks have been doing this for many years with VaR and stress testing requirements. But non-banks have typically not had this form of reporting obligation until they became ‘covered entities’ for IM.

The back testing is usually done daily, and regulators want to see rigor and maturity in testing over a certain period in the recent past and stress tests to cover extraordinary events. This is overly complex and is often a new process for many non-banks.

Our recent work has shown that many firms are finding the technical and operational aspects of back testing difficult to implement. The choice and maintenance of stress events is similarly challenging as it relies on expert judgement to find the appropriate scenarios for their own portfolio.

Summary

Collateral is now part of doing business for many firms, either through regulatory obligation or increasingly through counterparty requirements. Whether using clearing services (i.e., CCPs) or uncleared bilateral relationships, collateral is an important consideration for many firms.

We see the number of firms using collateral increasing and the complexities of managing the operational and technical challenges can be new and significant for many of them. The challenges can be managed with careful planning and some essential tools.

We have listed 5 challenges above but there are often many more. Each firm has their own idiosyncrasies with operational and technical improvements which are needed to manage collateral.