Phase 6 of UMR is looming, and cloud enabled tech could help

Phase 6 of UMR is looming, and cloud enabled tech could help

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By Torsten Joseph, Lead Solutions Consultant, Treasury and Capital Markets, Finastra

After the global financial crisis hit in 2007-2008, the G20 instigated a series of regulatory reforms, including international standards governing the opaque over-the-counter (OTC) derivatives markets.

From this, global regulators implemented the BCBS-IOSCO framework into the Uncleared Margin Rules (UMR), which were set to be phased in over a defined period and require the exchange of initial margin (IM) – the collateral collected by a counterparty, which is posted on a two-way basis to minimise current and potential risk exposure. Some examples of typical in-scope derivatives are FX options, physical and non-deliverable FX forwards, swaptions, interest rate caps and floors.

Phase 6 of the UMR is due to come into effect in September 2022 and is estimated to affect roughly 1000 firms. Whereas the first three phases largely impacted firms with the largest non-cleared portfolios, such as major bank groups, global dealers and some buy-side players, Phase 4 saw more of the buy-side being phased into the Standard Initial Margin Model (SIMM) calculations. SIMM is a common methodology to help market participants calculate initial margin on non-cleared derivatives. Dynamic back-testing may be required here to ensure accuracy.

Getting ready for UMR can be a significant, time-intensive process and as the regulation implementation journey comes to an end, this phase is expected to be the most challenging. If done well, it can also present a great opportunity for financial institutions to prepare for the future of derivatives by automating key processes and transforming their collateral management.

With time running out, what do financial institutions need to know ahead of the deadline?

Timeline for compliance

From March to May 2022, financial institutions should have prioritised determining the scope for IM. This involves calculating the Aggregate Average Notional Amount (AANA) – the sum of total outstanding amount of non-cleared derivative positions on a gross notional basis. The September live date is for all firms with an AANA of more than €8 billion (£6.7bn).

Once the threshold is determined, the next undertaking is solution planning and testing. In order to meet the deadline, financial institutions should have prioritised this from April to June, leaving a few months before September to iron out any issues. Time is therefore running out for firms, with only a few weeks to go, so they need to take action quickly.

Compliance requirements

When it comes to managing IM, there are five key requirements:

  1. IM calculation: financial institutions need to calculate their exposure. Most market participants are using the International Swaps and Derivatives Association’s (ISDA) SIMM, a common methodology to help market participants calculate initial margin on non-cleared derivatives. On top of this, in some jurisdictions, dynamic back-testing may be required.
  2. Threshold monitoring: financial institutions only need to exchange collateral where IM calculation breaches the agreed threshold. They therefore need to put a process in place which monitors this, such as a routine that regularly calculates the IM and alerts the collateral managers in case of a breach.
  3. Upon breach of threshold, the counterparts must be notified accordingly. Then, pledgor and secured calls need to be agreed with the counterparts.
  4. The security inventory must be monitored as firms must have access to securities which are eligible as collateral. The selected securities must then be priced and used as collateral.
  5. The collateral must be settled in a segregated manner, which means that firms’ own and counterparty custodian/tri-party agents must be instructed.

Addressing key challenges

The first major challenge for UMR compliance is that IM calculation is much more complex than variation margin (VM) calculation. It not only requires mark-to-market (MtM) margin, but there are also various sensitivities such as delta, vega or correlation. Accurate data on trades, cash flows and the market are crucial.

Secondly, there are process challenges. For IM, securities collateral is the market standard and most smaller firms are only used to cash collateral. There is also additional complexity surrounding inventory, eligibility, haircuts and settlement.

Finally, financial institutions may face challenges related to infrastructure. IM creates additional requirements for derivatives and collateral systems, such as the calculation of sensitivities according to externally specified rules and formulas and the processing of the results of these calculations in the operational collateral management processes. Financial institutions need to implement quick and seamless in-house developments or version upgrades, which is a big undertaking ahead of the September deadline.

The good news is that these challenges can be addressed by partnering with a company which provides a cloud-based collateral management service. This enables data to be collected, consumed and converted into settlement instructions and reporting. When it comes to calculation, it means that ISDA certified services guarantee correct SIMM calculations, there is no need to implement SIMM-specific formulas internally and service providers take on the heavy lift, such as managing market data and changes in the SIMM model.

When it comes to process-related challenges, the benefits are consistent end-to-end processes for VM and IM which mitigates operational risk, minimises costs for securities collateral and enhances straight through processing (STP) settlement due to custodian and tri-party connectivity via SWIFT. Finally, when it comes to infrastructure, an IM cloud service minimises the impact on existing on-premises systems, removes the need for costly in-house developments or version upgrades and enables quick onboarding to help financial institutions meet the upcoming September deadline.

Unlike other regulations such as the European Markets in Financial Instruments Directive, non-compliance with UMR Phase 6 isn’t simply a matter of being fined. It could result in trading being completely frozen, which means the stakes are high. Firms that are unprepared face enormous risks. To protect their business, they need to fast-track their strategy for compliance, or the potential consequences could be devastating.

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