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Phase 6 of the Uncleared Margin Rules (UMR) for derivatives trading arrives this September and will usher in new legal requirements for a wider group of funds. For funds that fall in scope of Phase 6 and exceed the margin threshold, the rules will add significant complexity to a fund’s document architecture.

As part of UMR’s staggered implementation, Phase 6 will see funds with an average aggregated notional amount (AANA) of over $8 billion now fall into the scope of the regulations. But not all funds over the new AANA level will be affected. Global regulators require that parties only enter into new legal documentation once they have or are soon expected to cross the Initial Margin (IM) threshold of $50 million.

However, for managers who believe their fund will eventually fall in scope, it is wise to begin redocumenting in the near term. Negotiating and implementing the new documentation will be time intensive, taking months or longer, and should not be underestimated.

To wit, Phase 6 requires an IM contract between the fund and the swap dealer. The International Swaps & Derivatives Association (ISD) has published an updated version of the contract, a Credit Support Annex, for the exchange of IM. Another contractual issue involves the requirement that initial margin be held in segregated custodian accounts. Thus, funds that don’t currently segregate initial margin will have to create an agreement with a custodian. Added to the contractual mix, the pair of initial margin postings (the swap dealer’s and the fund’s) will require separate-account control agreements, each negotiated between the swap dealer, the fund and the custodians.

Cutting through the Red Tape

These contractual requirements are not without some nuance. For instance, negotiations around the updated Credit Support Annex governing the exchange of IM will need to consider transfer timing and the minimum transfer amount; the specific margin approach deployed; who, exactly, will be responsible for determining IM and through which model (SIMM, Grid, etc.); and the threshold for posting IM. This is just the beginning. Funds that are in scope also have to determine a process to resolve collateral disputes and outline in detail which regulatory regime applies to which trades, in addition to many other considerations.

The rules that require Account Control Agreements (ACA) between the fund, the swap dealer and the custodians for the separate IM accounts can seem just as byzantine. The ACA is necessary to enforce the security interest that each respective party has over the IM held by the other party’s Custodian. Fundamentally, this means two separate three-way agreements.

The agreements themselves may seem like a Rube Goldberg invention, as the relevant parties establish what specific events allow the Secured Party to take “control” of the account; the conditions under which the transferor of collateral can take its collateral back; as well as operational details regarding timing of the transfers. While certain components of the account control agreements require negotiation, other areas are black and white. For instance, the Secured Party should only be permitted to provide an NEC when a termination event has occurred under the ISDA MA with all transactions being affected transactions.

Keep in mind, this only touches on the contractual considerations. The complexity is multiplied by custodians having more stringent AML and KYC requirements, including collecting detailed information on the fund and its management and investors. Coordinating the new operational processes, systems and reporting requirements will also be time intensive and require resources. That is why it is critical that managers with in-scope funds get a head start in implementing new documentation and sorting out operational procedures.