Uncleared margin rules – what you need to know

Eduardo Pereira, Product and Business Manager at Bloomberg, discusses the challenges the final two phases of uncleared margin rules (UMR) pose to trading desks, the increasing use of technology and data to address risk management, and how firms are identifying and implementing the tools to meet these new requirements.

Q: As the final two phases of uncleared margin rules (UMR) implementation approach, what are the main challenges that derivatives trading desks face?

A: Basel III’s UMR framework aims to reduce the risk of derivatives exposures. The rule is clear: if the firm has an aggregated notional exposure greater than €50 million, then it is in scope to compute an initial margin using ISDA’s SIMM (Standard Initial Margin Model) methodology.

The main challenge faced by traders is staying beneath the €50 million initial margin threshold, since exceeding that threshold comes with significant costs and cumbersome legal and custodian requirements, as highlighted by the Basel Committee and IOSCO in a March 2019 statement.

Although staying beneath the initial margin threshold sounds simple, in practice the trader will need to run sophisticated pre-trade analytics to determine the best way to minimise the SIMM number. Trading derivatives already incurs various costs, such as the cost of trading with a counterparty or the cost of funding the derivative, so any means to cut this additional margin cost is to be welcomed.

Efficient pre-trade analytics will need to determine exactly how much margin the trade will consume. For example, I recently spoke with some structure products traders who were struggling to pick an optimal counterparty from a list of potential counterparties. The most cost-effective trade requires a counterparty that will keep the SIMM number as low as possible. However, in order to determine the optimal counterparty, there needs to be a system in place to run the necessary analytics.

Q: Since UMR went live in 2016, only a small number of firms have been impacted by Phases 1-4. However, by September 2022, an estimated 1,000+ additional entities will be subject to UMR for initial margin (IM). What are the levels of readiness in the industry and which market participants are being left behind?

A: Phase 5 of UMR touches a mix of sellside and buyside firms, especially medium-sized banks and larger buyside firms, while Phase 6 is almost exclusively buyside-focused. From our understanding, banks are slightly ahead of the curve, possibly because they have dedicated staff, such as chief regulation officers, to onboard and implement downstream.

The larger buyside firms, on the other hand, seem a little less prepared. Some were relying on their custodian banks to conduct much of this work on their behalf. However, what they are starting to realise is that many custodian banks don’t have the technology to compute SIMM, or pre-trade XVA, and now they are coming to vendors for solutions. Firms scheduled to come into the fold in Phase 5 need to start their decision-making process to identify and implement the technology required.

Q: Getting ready for UMR can be a resource and time-intensive undertaking for firms not familiar with calculating initial margin. Can we zoom in on some other technical issues?

A: SIMM covers three distinct areas. First, there is a front office component, as the front office needs to run the pre-trade analytics to determine the optimal counterparty. Then, there is the risk office component, which involves back testing the SIMM number. The firm would need to determine if the number is reasonable given the P&L volatility in the book over a four-year period. It is a technical and challenging procedure.

The front office and risk functions take on the two main technical problem areas, since the third area – the operational process – can be off-loaded onto a custodian bank, and therefore does not pose as much of a challenge.

Q: The recent regulatory delay may have come with a sigh of relief for some in the industry. How have firms used this extra time?

A: Judging from our own feedback, clients weren’t especially focused on SIMM last year, as their resources were spread across a series of other challenges, such as FRTB implementation, XVA and the impact of the COVID-19 pandemic. They simply followed the regulatory guidance to the letter and pushed back their plans by one year.

Now, however, with Phase 5 fast approaching, there is a rush to meet implementation deadlines. The time has come for firms to resolve any outstanding issues.

Q: How does MARS SIMM enable clients to implement UMR with confidence?

A: MARS SIMM is an optimisation tool that enables traders to make the most cost-effective derivatives trade.

The pre-trade impact analysis determines both the risk of the trade and the aggregate risk of the target portfolios and thereby allows traders to choose the optimal portfolio with which to trade. This helps firms stay below that all-important €50 million threshold.

For example, if a trader has a choice of placing an instrument with Counterparty A or Counterparty B, the MARS SIMM pre-trade impact analysis allows the trader to determine the exact impact of trading with each counterparty. If the trade is positive delta, and the target portfolio of Counterparty A is negative delta, then the risk cancels and the SIMM reduces. However, if the trade is positive delta and the target portfolio of Counterparty B is positive aggregate delta, then the risk compounds, resulting in an increase in SIMM consumption. The trader would want to avoid Portfolio B and instead trade with Portfolio A since it reduces the SIMM number. MARS SIMM seamlessly allows for that, and leads traders to the optimal counterparty.

MARS XVA, a complementary MARS solution, can also measure MVA (Margin Valuation Adjustment), which, together with the aforementioned counterparty analysis, allows firms to compute the actual cost of placing the derivative.

The window firms have to prepare for implementation is quickly closing. As with all regulatory changes of recent years, firms will incur additional charges if their systems do not accommodate the new reality. MARS SIMM is an easy, cost-effective solution to the specific challenges posed by UMR.

For more information about Bloomberg’s related products, visit the Bloomberg MARS webpage or request a demo.