By John Straley, Chief Operating Officer at GlobalCollateral Ltd.

As another wave of derivative market participants began exchanging initial margin this September, the penultimate phase of the implementation of BCBS/IOSCO's 2015 uncleared margin rules, the “FINAL” phase, has now been divided into two further phases, providing smaller market participants with additional time to prepare by pushing back their compliance date to the new Phase 6 in 2021.

The recent announcement by BCBS and IOSCO that the Phase 5 split of the uncleared margin rules will be divided into two phases states that firms with an aggregate average notional amount (AANA) of more than $50 billion will need to comply with the rules by September 2020; whereas firms with an AANA of more than $8 billion will be in-scope by September 2021. When the threshold drops to an AANA of $8 billion, it is estimated that several hundreds of smaller firms will be affected, a group likely to include regional banks and smaller asset managers. While the creation of Phase 6 provides these firms with more time to prepare, it is vital that this additional time does not create complacency and should be used wisely, given the scale of work necessary to meet the deadline.

The first key challenge Phase 6 firms will face is determining whether they will have breached the new threshold limit of $8 billion notional. This alone will prove daunting for multi-managed pools of assets, as the closely guarded distribution of assets across multiple managers is key to the successful returns that some of these pools generate year after year. In order to meet the Phase 6 deadline, this analysis needs to begin as soon as possible. 

Once a firm is determined to be in scope, according to ISDA, market participants must carry out several steps ahead of the compliance deadline. The first step is to disclose the status of estimated in-scope entities to counterparties to provide those counterparties with sufficient time to prepare. After disclosure, firms are to exchange information with each counterparty and then foster an agreement on how IM will be calculated, determine minimal transfer amounts and IM thresholds, plus concur on eligible collateral and haircuts with each counterparty and with custodians as required. The next step is establishing custodial relationships, which can be a lengthy process involving contracts and other negotiations. ISDA estimates that for market participants caught by the Phase 5 and 6 IM requirements, more than 9,000 new relationships will be generated, all requiring new or amended documentation. 

An additional challenge for Phase 6 firms is that a significant number of the 'in-scope' entities historically have neither exchanged IM, nor have they developed the third party operational and control processes necessary to manage collateral. As this is regulatory mandated IM, many of the firms have opted to establish accounts with their main custodian to hold the margin. This means communication lines with counterparties’ custodians will need to be established for participants to effectively monitor the collateral posted on their behalf. This has historically challenged the operational processes and communication abilities of the industry, as communication lines are not necessarily in place for custodians that will allow them to take instruction from their client counterparts, rather than directly from their client. Faxes and/or email are a common type of communication in the collateral space today for custodians involved in this activity, which leads to significant shortcomings with regards to automation and achieving efficiency. 

As this market grows over the next few years, communication with third party custodians will need to become more efficient. If not addressed, it could lead to increased risk in other markets, driven by collateral not released or received in a timely manner, as the collateral will be needed for settlement of trades.      

Once the custodial relationship is in place, firms must address operational resources to ensure they have the requisite workflows and processes in place to meet their compliance obligations. Firms also will have to negotiate the necessary documentation for the preparatory steps, which may involve revisiting contracts that have remained unopened for up to a decade. Once all these steps have been completed, market participants must ensure enough time remains for testing their new processes ahead of the Phase 6 deadline. 

Historically, some asset management firms have tended to invest in technology designed for risk management or portfolio-trading systems, as opposed to automation for operations and have relied on custodians and administrators to fill that gap. It’s not clear that model is going to work in the future so testing new processes and potential new technology will be paramount to success.

As the next wave of IM requirements approaches Phase 5 firms should be accelerating their preparations for the 2020 deadline. But the challenge posed by Phase 6 implementation should not be delayed, when a large number and various types of market participants will be captured. The change these firms will potentially undergo could change their business model.  Those market participants should be preparing now, first to establish whether they are in scope and if so, to tackle the steps necessary to meet the 2021 deadline.

By John Straley, Chief Operating Officer at GlobalCollateral Ltd.