A wide universe of hedge funds and institutional investors is starting to re-allocate its derivatives exposures to a larger number of counterparties to avoid hitting the $50 million threshold that would force them to move collateral to an external custodian.
With over 1100 financial firms being brought into the scope of pivotal post-2008 crisis derivatives rules over the next 11 months, investors are re-gearing their derivatives strategy and stepping up tech solutions to monitor their exposures to a single counterparty more closely.
“Clients have been very smart on how they operate now,” Eduardo Pereira, SIMM Product Manager at Bloomberg LP, said referring to the strategies being implemented by hedge funds, asset managers, insurers and pension funds as they prepare to comply with Uncleared Margin Rules (UMR) set out by the Basel Committee on Banking Supervision and the International Organisation of Securities Commissions (IOSCO).
The UMR framework has been phased in globally since 2016 with the goal of reducing counterparty credit risk on non-cleared over-the-counter (OTC) derivatives, requiring the two sides of a bilateral transaction to post collateral (in the form of highly liquid assets, also referred to as initial margin, or IM) into a segregated custodian account.
Up until September this year, however, the rule only affected a small portion of sell-side banks with hefty trading books. Conversely, the last two stages of implementations (Phase 5 and, from September next year, Phase 6) will hit a much larger slice of the financial sector, expanding requirements to all those investors whose outstanding non-cleared derivatives positions exceed $8b – down from a threshold of $750 billion in 2019 and as much as $2,25 trillion in 2017.
However, in 2019 the Basel Committee and IOSCO clarified a further threshold that practically reduced the amount of affected contracts to those that would require an IM bigger than $50 million – a key level that Pereira said the financial industry is now re-strategising around.
“Clients are being very careful in terms of not exceeding that $50 million threshold, because there is a huge operational burden as well as legal and custodian burden,” he told bobsguide.
“If a firm has maxed out its exposure with a certain counterparty, I think it will look into trading that instrument with another counterparty, even though that might not be its preferred counterparty to trade with.”
New tech needs for pre-trade monitoring
If the calculated IM level on a bilateral trade remains below $50 million, then “essentially, buy-side and sell-side firms are merely monitoring that exposure versus that $50 million,” Pereira noted.
However, once the expected IM crosses that threshold and the firm is required to move liquid collateral into a segregated account, “effectively, that money has left the buy side firm and you’re not actually allocating that within the firm.”
“You cannot earn an interest rate on the potentially significant initial margin amount,” Pereira said, “and that obviously is of cost to that firm.”
Being able to identify and monitor the level of derivative exposure to a single counterparty so that it doesn’t cross the $50 million IM mark has thus become increasingly pivotal for institutional investors, Pereira said, spurring the need for new technology to handle pre-trade analytics.
“They’re really asking us to solve this conundrum, which is: ‘How can we manage this? And what kind of pre-trade analytics can we run here in the front office to remain below that threshold?’”
In particular, traditional asset managers, which represent the largest slice of the last implementation phase kicking in next year, “are the ones that are actually posing this issue about trying to optimise margin between counterparties.”
“On the pre-trade side, on the ‘What if’ scenario analysis of when do clients actually reach that threshold – That is a fundamental question they have.
“They can only [monitor] that if they have pre-trade analytics that allows the in-scope firm the ability to run incremental trades on the portfolio,” Pereira argued.
“So, I think Phase 6 will be the most interesting from a technology point of view.”
Stepping up SIMM back-testing and governance
Firms’ needs in response to UMR compliance are thus evolving on two separate levels.
On one side, Pereira noticed a clear move towards higher demand for APIs that can lend firms more flexibility in terms of handling and accessing trade data, such as sensitivity levels and back-test results.
“I definitely see a fundamental shift from when I started the project three years ago, [when] clients really wanted to run the functions on terminal. Now it’s all about ‘Let me consume this number from you via a programmatic access,’ meaning an API calculation.”
“That fundamentally is a technology question that we are looking at daily with our engineers – how to make it faster and more accessible to clients and less cumbersome for clients to access that information.”
Meanwhile, on what could prove a more problematic level, buy-side firms are coming under added pressure to integrate systems for calculating initial margins, such as the Standard Initial Margin Model (or SIMM) developed by the International Swaps and Derivatives Association.
However, these risk-sensitive quantitative models, which provide an alternative to regulators’ less nuanced standardised grids, will require establishing additional back-testing and governance systems to get approval – something not all investors are currently up to speed with.
At the current stage, in fact, “sell-side firms are more sophisticated in understanding the moving parts of the model, because they were first to be in scope,” Pereira said, while buy-side companies are often postponing or delegating a step that is operationally resource-intensive.
However, global regulators including the European Securities and Markets Authority, the Hong Kong Monetary Authority and the US’ National Futures Association have set out clear SIMM approaches that will translate into “a significant regulatory requirement” for buy-side firms too – in terms of back-testing, providing the correct model documentation and setting out the right governance frameworks.
“But we see the sell side being a lot more in line with the regulators in terms of producing back tests, [while] I think the buy side is kind of relying on the sell side for that,” Pereira warned.
“Although that might change in the future,” he said.
As more firms gear up for Phase 6 compliance, the shift to setting up their own SIMM governance systems could create calculation mismatches, he added.
“The sell side will have a certain pricing approach and the buy side might have a different pricing approach, resulting in different Greeks. And when you push these differing Greeks into the SIMM model, that is where the discrepancy could potentially happen.”
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