As we inch our way towards a post-pandemic horizon, firms will need to continue to adjust current operating models to navigate cautiously in an evolving crisis-challenged environment.
Against this backdrop, Hasan Rauf, Executive Director, Head of Business Development – APAC, DTCC, spoke with Rishi Kapoor, Director, Public Policy, Asia-Pacific, International Swaps and Derivatives Association (ISDA), to gather insights on managing collateral in the new reality world.
Rauf: With the extra time given for the go-live of Phases 5 and 6 of the Initial Margin (IM) requirements, how soon should firms start preparing for compliance? And how many firms are expected to start posting IM in 2021 and 2022?
Kapoor: It is important to note that while the timelines for Uncleared Margin Rules (UMR) have shifted by a year, the compliance requirement itself has not. Firms should not hold back preparations for IM requirements until this time next year, as there are significant challenges that firms will face in getting operationally ready. Our analysis shows that the impact is pervasive across the industry, with more than 9,000 counterparty relationships having to comply across Phases 5 and 6. And sitting behind these relationships are more than 18,000 segregated IM custody accounts that need to be set up, tested and ready for posting and collection of IM prior to the go-live date. At the firm level, several divisions will be involved in ensuring readiness for Phases 5 and 6 – including onboarding, legal, compliance, operations, technology and risk, to name just a few. It points to the need for a firm-wide project management methodology to meet these strict regulatory requirements, including documenting every bilateral relationship in accordance with the IM requirements, setting up third party segregated accounts and adopting a model for IM calculations to minimize the dispute resolution process.
Rauf: What is the impact of COVID-19 on the industry and the implication of COVID-19 on firms’ margin calls?
Kapoor: According to a report, COVID-19 and the Impact on Liquidity, published in June by ISDA and Greenwich Associates, 172 buy-side and sell-side market participants observed that the top financial event related to COVID-19 that disrupted liquidity was perceived to be reduced risk appetite of banks. Trailing close behind was the sudden need for short term funding by corporates.
We also found that the primary response to managing liquidity issues was to trade in smaller sizes – a common response from the buy-side. We also saw that liquidity deteriorated in multiple product sets in nearly all regions.
Within the margin world, about a third (34%) of the respondents rated cash needs to meet margin calls as a key COVID-19 related financial event that disrupted liquidity. The survey also brought to light the race for cash to meet high levels of unexpected margin calls as exchange-traded derivatives and equity markets went on a precipitous decline. The liquidity impact is further highlighted in the same survey, with 27% of respondents citing margins being raised to the point that their strategies were no longer producing enough returns in their top three major obstacles to plain vanilla swaps liquidity during COVID-19.
Rauf: With firms focused on business continuity and managing risk, regulators have responded by extending deadlines for compliance. While these measures have enabled firms to allocate resources efficiently, there are still operational problems challenging firms. What is your understanding and observation on this front?
Kapoor: While the regulatory extensions have provided some level of flexibility to realign priorities, COVID-19 also came unannounced. The COVID-19 experience underscored the different approaches to managing business resilience – between firms that have embraced technology to simplify business operations, and firms that are still steeped in manual processes. When we combine these manual processes with smaller trade sizes, high trade volumes, increased volatility and sudden jumps in margin levels, non-automated processes clearly expose firms to higher levels of operational risk. And this will invariably lead to high capital charges – reinforcing why some firms struggle to keep their heads above water while others are able to swim away in times of market stress.
Further, negotiating and executing margin documentation could be a time-consuming and laborious process, when handled manually via emails and faxes. Given that most firms in scope for Phases 5 and 6 will be new to exchanging IM, affected firms should leverage automated solutions to replace current outdated manual processes. This will bring about greater efficiency and mitigate operational risk for the industry.
Rauf: Can you outline ISDA’s progress and development in pushing for standardized processes and infrastructure to be adopted globally?
Kapoor: With the sheer volume of regulations hitting the industry following the global financial crisis in 2008, most firms typically only had time to implement quick-fix solutions. Remedial actions, if any, to improve processes were considered later. Over time, this has resulted in a patchwork of “Band Aid” implementations that is not sustainable in the long term. Additionally, the interpretation and mapping of regulatory requirements to internal systems is often based on an individual firm’s interpretation of the rules.
Leveraging our 35-year track record of developing industry standards, ISDA’s Common Doman Model (CDM) was forged to provide a digital standard for representing transactions and events for derivatives and other financial products as they move through their lifecycle. This enables consistent regulatory interpretations, and also enable firms to map internal systems to a standard business logic, thereby eliminating constant and unnecessary reconciliations. The CDM also provides a digital standard for collateral exchange and transfer processes, bringing collateral providers, takers, custodians, managers and optimizers into the ecosystem.
Another initiative under ISDA’s digitalization strategy is ISDA Create, an online platform for firms to digitally negotiate, deliver and execute documents and capture, process and store data from such documents, thereby providing users with a complete digital record of such documents. The first module, ISDA Create – IM, was launched in January 2019, with amendment agreements and interest rate reform documentation being added recently. The digitized version of the ISDA Master Agreement Schedule will be added in Q4 2020.
Rauf: As firms prepare for the next new normal, how key is digitization of legal agreements and do you see the transition to digital documents being established as a new norm across markets?
Kapoor: In June, we launched a new drafting tool – the ISDA Clause Library – to bring greater standardization to frequently negotiated provisions and common variants of these provisions within ISDA documents. This will help to improve the accuracy and consistency of legal agreement data, as we deliver these digitized legal documents through ISDA Create.
That said, we believe that it is critical to transform processes to meet the opportunities of the digital era. This will help to improve the efficiency of the entire ecosystem by enabling structured data to be leveraged for downstream processing. Our CEO, Scott O’Malia, likens the transformation to moving away from 2G and towards 5G – in the derivatives world. Digitization and hence digital transformation will become the new norm across financial markets, not only because current processes are costly and inefficient, but also because there are tremendous opportunities that lie ahead in the digital world. We believe that those who join the journey will be best placed to capitalize on those opportunities.