Here are five things you need to know about Uncleared Margin Rules and how they might affect your firm in the future.
1. What are Uncleared Margin Rules (UMR)?
UMR is a set of rules that apply to margin (i.e., collateral) on uncleared OTC (“U-OTC”) derivatives. U-OTC are almost exclusively traded under the legal framework provided by the International Swaps and Derivatives Association (“ISDA”), namely the ISDA Master Agreement (“ISDA MA”), and collateral for them is exchanged under an ISDA Credit Support Annex (“CSA”). The Rules apply to variation margin (“VM”) and initial margin (“IM”) on U-OTC. The Rules for VM were implemented in 2017. At a high level, UMR for IM requires that in-scope counterparties exchange IM in line with regulatory requirements (amount and type of collateral) and that such collateral be held in segregated accounts.
2. How do I know if my fund has come into scope?
In order to determine whether you are subject to IM under the UMR requirements, you need to determine if, at a group level, your consolidated notional non-cleared derivative balance exceeds the compliance threshold. The threshold is your average aggregate notional amount (AANA) of uncleared OTC derivatives calculated on the last business day of March, April, and May starting in 2022 and every year thereafter. If this is greater than $8 billion, then your fund is subject to the margin rules. If you haven’t already prepared, you should start working out now whether you are likely to exceed this threshold in the future.
3. What are the different types of margin?
Margin – otherwise known as collateral for U-OTC – is essentially a transfer of cash or securities to one party that is meant to protect it against losses resulting from the default of the other party to the trade (i.e., such party’s inability to pay or satisfy its obligations).
There are three types of margin:
- Variation Margin (“VM”). The margin in a U-OTC transaction is transferred between the parties based on the movement of the underlying asset’s mark-to-market value. This means that during the transaction’s lifespan, the value of the underlying asset will fluctuate and, thus, affect the value of the transaction on a given day if it were to mature. VM is used to capture changes in unrealized profit or loss on the trade, and it is usually transferred daily using the previous day’s mark-to-market value of the asset.
- Initial Margin (“IM”). IM is intended to serve as a buffer throughout the life of a transaction, which protects one party against the default of the other party. Unlike VM, IM is not based on the mark-to-market value. Rather, IM is based on the theoretical losses that a party might suffer if the other party to the transaction defaults. These losses represent the expected movements in the market that might occur before the non-defaulting party is able to close out its swap exposure.
- Independent Amount (vs. IM). Prior to the advent of UMR, Swap Dealers (SDs) recognized the risk that a loss could occur in the event of a counterparty/fund default due to market movements between the time of the last VM movement and the closing out of the swap exposure. To account for this risk, SDs would impose an additional margin requirement on certain counterparties whom they viewed as having a high-risk profile, typically funds.
This additional margin requirement may be calculated in many ways, depending on the particular arrangement between the SD and the fund, as well as the SD’s credit appetite. Because an SD has a better credit profile than a fund, the SD would impose this additional margin requirement on the fund. The SD would typically not post this additional margin to their fund counterparty in return. This additional margin requirement is referred to as independent amount (“IA”) or initial margin. The terms IA and IM are synonymous and often used interchangeably. Following the 2008 financial crisis and the fall of Lehman Brothers, market participants, and regulators were compelled to accept the notion that although an SD may have a better credit profile than a fund, they are not infallible. Thus, the fully bilateral rules for regulatory IM were born. Since the term “initial margin” was used in the regulatory rules, the industry has now generally applied the term “independent amount” to refer specifically to the additional margin required by SDs to funds not prescribed by regulation.
To recap, IM is required by the Uncleared Margin Rules. IA is the additional margin that was—and will continue to be—required by SDs of their fund clients. Both IA and IM (as well as VM) will continue to co-exist, and their interplay will be determined by the margin approach selected by the counterparties to a U-OTC transaction.
4. How can I keep track of portfolios that are about to breach threshold amounts?
When working with our clients, the Hazeltree team stresses the importance of leaving plenty of time to set up a UMR program. While the process is certainly manageable, funds that fell in scope for Phase 6 were subject to rules that added significant complexity to a fund’s document architecture.
Additionally, the grace period for compliance may be shorter than you think. Once subject to UMR, firms do not have to post collateral while their IM requirement is under the $50mm threshold. However, once a fund breaches the IM threshold, the firm is expected to post the requisite collateral immediately. It is, therefore, critical that firms that are not yet in scope actively monitor AANA, continue tracking it over time, and begin to document any items that will be needed once they become in scope. Firms that make the investment now will be better positioned for any additional future regulations.
5. What Role Can Technology Play?
Technology can be a key advantage for companies seeking to establish an efficient and compliant UMR program. Firms find advantage by leveraging platforms explicitly designed for use by the investment management community, which faces challenges unique to the industry. For example, a smart investment in technology should involve platforms that can be deployed in multiple ways to monitor and manage UMR requirements, including:
- Calculating each margin call according to any of the 3 industry IA/IM approaches (Distinct, Greater of, Allocated)
- Designating separate initial margin MTA, rounding, threshold, eligible collateral, and haircuts per agreement for both parties to the agreement
- Utilizing SIMM and/or Schedule values for both parties to the agreement
- Providing visibility to show internal/external UMR data side-by-side
- Calculating the RQV for any triparty account for use in movement booking
- Calculating AANA on a daily basis for monitoring UMR status
MITIGATE YOUR UMR RISK
Hazeltree Fund Services has some of the industry’s deepest knowledge of UMR issues and offers some of the most advanced technology for UMR compliance. Hazeltree is a next-generation collateral and exposure management solution designed specifically for the buy side. Our UMR solutions streamline compliance with these complicated regulatory collateral requirements. Hazeltree enables clients to monitor counterparties, mitigate risk, and optimize capital usage across their uncleared OTC agreements.