Summary

The regulatory requirements for Initial Margin (“IM”) segregation, linked to non-cleared derivatives, came into force in 2016. The phased implementation schedule first affected those most active in the OTC market, followed by a greater and more diverse range of counterparties. Of the five waves scheduled, Waves 1 and 2 are complete, involving mostly sell-side organisations, with Waves 3, 4 and 5 scheduled for September 2018, 2019 and 2020 respectively. Some buy-side institutions will be caught by Wave 3, but most will be captured in Waves 4 & 5 as the threshold notional amount of non-cleared derivatives reduces from EUR 1.5tn in 2018 to EUR 0.75tn in 2019 and EUR 8bn in 2020.

Challenges

There are two technical challenges that need to be solved by market participants to enable successful implementation for future Waves:

1. Custody Models
The broker and custody market has developed new custodial models to be able to comply with the IM regulations. The sell-side institutions affected by Waves 1 & 2 have almost 100% implemented Tri-party arrangements between themselves. The industry faces a major challenge in that the Tri-party model is not appropriate for all and certainly not for a large part of the buy-side community, and therefore alternative solutions will need to be implemented. Two new model options are:

1. Full bi-lateral custody model – each party appoints an independent third party custodian with an appropriate (certified) Account Control Agreement (“ACA”) in place; or
2. Hybrid custody model – buy-side appoints third party custodian to face the broker’s Tri-party agent.

Neither of these models are yet established and neither yet have an agreed end-state in terms of messaging and communication – much of which is being driven by and dependent on individual custodians’ capability in the interim.

2. Calculations
Wave 3 will see the first use of schedule-based calculations. Up until now the sell-side organisations have almost universally followed the Standard Initial Margin Model (“SIMM”) route. The limited scope of many buy-side derivatives portfolios means that SIMM is relatively expensive, compared to schedule-based calculations, and provides no additional benefit to buy-side firms.

The OTC industry is only now beginning to grapple with these two challenges. The focus up until now has rightly been on execution for sell-side firms in Waves 1, 2 & 3 but given time pressures for delivery and the number of firms that will be affected in Waves 4 & 5 there needs to be a further push for a consensus on industry practices that will lead to compliance for all organisations affected by the regulation. Coupled to this, custodians may also be unaware of the full route to certification of their custody solution.  In the interests of time and efficiency, parties involved in Waves 1 and 2 agreed to standardise their documentation as much as possible and agreed to a central review of all documents via the Derivatives Lawyers Forum (“DLF”) to confirm compliance with the regulations. This process is likely to change for Waves 4 and 5 with an ISDA forum being set up for document review.

The Heavy Lift:

Solving the technical challenges outlined above will not necessarily result in full industry compliance. The level of effort required for each counterparty relationship is significant. The challenges are not intrinsically complex in isolation, but taken together with deadline pressure and an increasing number of counterparties captured in Waves 4 & 5 means that there is a need for clarity, communication and consistency as soon as possible.

Examples of the work required for each counterparty relationship include:

• Documentation (CSD, ACA) – Dealer, Investment Manager, Counterparty, Custodians;
• On-boarding and KYC of counterparties at new custodians as collateral receivers;
• Account opening – broadly two for each collateral agreement (although debate is ongoing as to whether an omnibus account could work) – Dealer & Custodian, Counterparty & Custodian; and
• Messaging and operational processes, which are potentially different for each custodian – Dealer & Custodian, Investment Manager, Counterparty & Custodian

How Holley Holland Can Help

Holley Holland has extensive technical and operational experience and capability in the field of collateral management. Our key credentials include:

• Developing and implementing collateral capability within Insurers to meet current industry standards;
• Advising major buy-side organisations on implementation of solutions to ensure compliance with Initial Margin regulations; and
• Experience of holding leadership positions within ISDA’s Collateral Committee.

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