It has been said that you can never let a crisis go to waste. And rightly so, radical reforms should be implemented to prevent history from repeating itself. One of the most notable changes introduced following the global financial crisis is the Uncleared Margin Rules (UMR) – phased-in since 2016 to mitigate credit risk exposures in the global over-the-counter (OTC) derivatives markets. With the last sprint of UMR Phase 6 commencing on September 1, 2022, are we reaching our destination for UMR?
Related: Tackling UMR Challenges with MTU
DTCC recently organized a Collateral Management Forum in Asia Pacific where Amy Caruso, ISDA Head of Collateral Initiatives and Bob Stewart, DTCC Executive Director, Institutional Trade Processing, discussed what impacted firms should consider before and after the final implementation of UMR.
Eye on Risk Mitigation
Caruso stressed the importance of turning to automation and workflow standards to take the operational risk out of collateral processing. “Firms should adopt a holistic view of the overall collateral needs, not just the regulatory aspect of the UMR mandate to better manage collateral inventory and margin settlement. At ISDA, we have developed data standards, including the Common Domain Model, and operational practices, with our members – to help streamline the end-to-end collateral management lifecycle.”
Stewart concurred, explaining how automation is key to reducing reliance on the fax machine and manual workflow. “The fax issue was further exacerbated during the early days of Covid-19 in March 2020 where the industry struggled to cope with the sudden spike in trading volumes and collateral settlement fails amid remote working conditions,” he said. “The process of calling back a counterparty to validate instructions sent via fax to proceed with collateral processing could not happen in a work from home environment – creating liquidity risk and overdrafts in client accounts.”
Firms are also encouraged to look beyond the regulatory deadline to look at other areas that could be improved when upgrading existing systems to meet UMR operational requirements. Illustrating her point, Caruso indicated that the automation process to manage collateral inventory for initial margin (IM) could be extended to repurchase agreements and security lending – to maximize IT spend and hence generate a higher return on investments.
Drawing on Insights from Previous Phases
Stewart recommended planning ahead as the key to ensure compliance: “Phase 6 will impact approximately 700 to 800 or more buy-side firms in Asia Pacific and globally. As these buy-side firms may be new to the collateral management ecosystem, they need to have an early and clear understanding of processes involving global dealers and custodian banks – to be able to exchange IM efficiently with the right infrastructure established. While the big banks and broker-dealers have sophisticated systems and trading desks with extensive experience knowledge to manage collateral processing, there are tools out there that can reliably support the collateral workflow for the less equipped buy-side firms, saving them time and resources to reinvent the wheel.”
He continued, “Some buy-side firms may choose to keep below the US$50 million IM threshold to remain out of scope.” Stewart cautioned that there must be a plan set up to allow collateral to be moved quickly due to unforeseen market events where the IM exposure may suddenly increase, breaching the threshold with one or more counterparties.”
In phases 1 through 4 of UMR, the IM exchange took place solely at triparty venues. The operational obligation varies slightly for Phases 5 and 6 firms – they are required to post IM in a segregated account using either a triparty custodian or a third-party custodian structure.
Caruso highlighted, “With the third-party custodian structure, the secured party will need to authorize the release of collateral to the pledger and the fax machine has been commonly used to communicate this step. In contrast, the entire process is automated with the triparty structure adopted by the broker-dealers and some Phase 5 and Phase 6 entities.”
As many Phase 6 entities will likely use the third-party custodian structure, Caruso remarked that the industry refrain – “axe the fax” – should not be ignored in the collateral space where automating steps like the release of collateral will help to reduce settlement fails and cost from heavy fines.
Elaborating on the value of buy versus build for smaller, in-scope buy-side firms, Stewart explained, “by leveraging industry utilities like DTCC’s Margin Transit Utility (MTU), the entire margining process is made easy with seamless connectivity to tri-party and third-party custodians. The automation movements include real-time updates, confirmation of settlement and end-of-end day position reports and attaching the correct golden source standing settlement instructions from DTCC’s ALERT® database to facilitate margin settlement.”
Citing a success story, Stewart shared how one, MTU user raised their “We have seen the settlement efficiency rate from 92% pre-implementation of a MTU user that went from a pre-implementation rate of 92% to 98.99%, post-implementation. “This was partly achieved by eliminating manual processes and a significant volume of faxes, sent over a defined period of time,” said Stewart. “The time-consuming task of performing call-backs to authenticate the faxed instruction was no longer required, providing staff to focus on higher-value activities for clients.”
Phase 5 vs Phase 6
Caruso summarized the difference between the last two phases of UMR: “For Phase 6, the number of in-scope entities and corresponding counterparty relationships is many times higher; going forward firms need to have an annual process to calculate the aggregated average notional amount (AANA) and determine if counterparty relationships are in scope to exchange IM.”
She added, “Given that Phase 6 firms could have a diverse number of counterparties and not immediately hit the IM threshold with one or more of their counterparties, compliance may kick in well after September 2. Keep your resources in place to expedite operational readiness.”
To accelerate preparation, Caruso urged firms to visit the ISDA website where there is a wide range of resource materials including toolkits, checklists, and cost-benefit analysis assessments in the ISDA Margin InfoHub section.
“Make an early determination on whether to buy or build based on business and operational needs, cost saving opportunity and the value proposition offered by industry utilities,” Stewart advised. “And look beyond the regulatory deadline to decide how best to leverage automation to holistically support and transform your strategic initiatives.”