What Do Managers Need to Do to Prepare for UMR? Five Things to Consider

This blog is part of our comprehensive UMR whitepaper. Click here to see the full paper.

Fund managers have many decisions to make surrounding the new Rules for IM on U-OTC. They will need to assess whether their fund(s) will fall within the rules and, if they come in scope of the rules, how they need to prepare for the challenges ahead.

Funds falling within the Rules for IM on U-OTC will be required to make a series of comprehensive changes to their operations and legal agreements around U-OTC. The time to begin the dialogue and planning process around the rules is now. If managers do not adequately prepare for the coming changes in a timely manner, their ability to execute their trading strategies may be seriously disrupted. ISDA has warned that unprepared in-scope counterparties may become unable to trade non-centrally cleared derivatives, limiting their options for both taking and hedging risk, and also potentially impacting liquidity in the derivatives markets more broadly.[1]

Below are five areas managers need to consider at this very moment.

1. ACT NOW: Determine if you are in-scope (AANA Calculations)

The first step for managers is calculate their AANA to see how they compare to the thresholds for the next phase of implementation. The AANA determination months for Phase 6 are upon us (March-June 2022). It may prove difficult to calculate this with accuracy and compliance bottlenecks may form around deadlines set by regulation, making it difficult to get last-minute help and advice.

Managers will be required to make representations to their SDs shortly as to their status. If a manager is unable to make the representations, SDs may refuse to continue to trade.

2. Current and projected IM requirements

Managers should then determine your IM requirements with each SD group (using either grid or SIMM). Next, consider how this might change in the future in accordance with projected Fund growth and changes in strategy depending on market developments. This will provide a good sense of whether a fund is close to the IM Threshold.

The use of a vendor specialized in margin and SIMM calculation can be helpful. These numbers are not always easy to obtain.

3. Choose service providers

If a manager determines that they are in scope, there are four categories of service providers that they should consider:

Technology provider – to assist with AANA, IM calculations, and operations systems/tools
Custodian – necessary to hold IM
Legal counsel – to assist with document negotiation, provide advice and onboarding assistance
Consultant – optional, but useful to assist with overall implementation of the IM Rules (project management, technology and ops)

4. Disclose your status and consult with your swap dealers

It is important to be in close contact with your SDs to disclose whether you are in scope, determine which UMR rules apply, agree on a Collateral Segregation Model, agree on eligible collateral schedules, and put new legal documentation in place.

Funds will be required to disclose their status (i.e., AANA calculations) to their SDs either directly or via a market utility. [2] (https://hazeltree.com/what-do-managers-need-to-do-to-prepare-for-umr-five-things-to-consider/#_ftn2)

5. Options/alternatives for managers to mitigate or avoid the impact of the rules

There are three main areas to consider here. The first is reducing AANA.

Managers may wish to reduce their total notional outstanding below the relevant thresholds so that they are not captured by the rules:

Portfolio Compression – by minimizing the total number of offsetting contracts, a fund can reduce the notional value of their portfolio, thereby reducing their gross notional exposure. This may allow Funds to stay below key regulatory thresholds and potentially avoid the hassles that come with the Rules, such as the multiple workflows required for monitoring new and legacy trades.
Shift away from U-OTC to increased use of futures or cleared OTC to reduce AANA.
Alter strategy more generally. For instance, a multi-strategy fund may consider removing some strategies that require intensive use of U-OTC.

The next area to consider is reducing IM. If reducing AANA isn’t possible, and a manager must be subject to the Rules, they may wish to consider keeping IM at each SD group below the USD 50M threshold. There are multiple means through which this can be done:

Use more SDs so that the amount of IM at each SD remains below the 50M threshold. In doing so, at the time of executing a trade, a manager will need to consider not only the bid/ask (or price of the trade) but also consider the collateral implications such as whether a trade triggers IM to go above 50M with that SD.
Shift away from U-OTC to increased use of futures or cleared OTC to reduce IM with an SD group.

Lastly, if a fund remains subject to the rules, a manager could consolidate its U-OTC positions at fewer SDs so that there are fewer segregated collateral arrangements needed, reducing their legal and operational burden.

While the changes required to adapt to the Rules are numerous, managers can capitalize on this moment and turn it into an opportunity. Managers should view the current moment as a perfect time for overhauling their legal and operational strategies. By properly renegotiating the terms of their prior legal agreements, streamlining and integrating new technologies into their operational workflows, and forming new relationships with the service providers that will be required for compliance with the Rules, managers can transform a regulatory headache into a competitive advantage.

[1] International Swaps and Derivatives Association and Securities Industry and Financial Markets Association, “Initial Margin for Non-Centrally Cleared Derivatives: Issues for 2019 and 2020” (Jul 2018) Discussion Paper, online: https://www.isda.org/a/D6fEE/ISDA-SIFMA-Initial-Margin-Phase-in-White-Paper-July-2018.pdf at 3-4.

[2] See https://www.isda.org/2016/10/26/isda-regulatory-margin-self-disclosure-letter-2/