Paul North, head of product management EMEA at BNY Mellon, looks at how custodians and service providers are responding to margining rules set to come into force this year.
Derivatives users now have certainty on the timetable for central clearing of interest rate swaps (IRS) in Europe, but they can ill afford to ignore the upcoming changes to bilateral margining of less liquid instruments. Under the European Market Infrastructure Regulation since November 2015, market participants can mark in their diaries the dates for frontloading and clearing IRS. Other liquid swaps will follow, but existing contracts and many less liquid swaps will be subject to new margining rules for non-cleared derivatives, starting September 2016, based on guidelines drafted by the Basel Committee for Banking Supervision and International Organisation of Securities Commissions.
The new margin obligation will apply to transactions between financial counterparties and the non-financial counterparties exceeding the clearing threshold.
In a mechanism that reflects margining of cleared derivatives, both initial margin (IM) and variation margin (VM) requirements are considered. The exchange of VM covers current exposure and will be one-way at any one time. IM to cover future exposure will be two-way throughout and might be calculated using either a quantitative portfolio margin model or by reference to a standardised IM schedule against percentage of notional exposure. For systemically important derivative market participants, both IM and VM must be exchanged from September 2016. However, market participants with lower notional exposures will have staggered IM implementation dates based on thresholds starting at €3 trillion in 2016 and falling progressively each year to €8 billion in 2020. The exchange of VM will be far more abruptly implemented, with a second deadline occurring in March 2017.
To date, uncertainty about the timeline for central clearing has overshadowed non-cleared margin rules. Now that they are gaining attention, the impact of margin exchange on non-cleared derivatives will raise more questions. For example, what available assets might derivative contract-holders have that meet the collateral eligibility requirement? And if they don’t have assets immediately available, what will be the cost of obtaining such assets? Other systemic risk questions also remain open, such as the effect on liquidity for margin-eligible instruments.
Service providers and custodians have been developing products and solutions.
In relation to the eligibility requirement for IM collateral, derivative contract holders will need to identify how to use their existing assets to obtain eligible collateral. This could be achieved through the use of collateral transformation programmes such as securities lending, or repo transactions if delivering cash to a counterparty. Both the securities lending and repo markets are accessible via custodians, which are evolving their capabilities to facilitate demand.
To counteract concerns over collateral scarcity, custodians have developed collateral optimisation solutions, ensuring that contract-holders retain their most valuable liquid assets for trading and use less liquid assets as collateral.
As well as reviewing the capabilities of service providers, market participants will also need to reappraise their internal processes, with a view to greater co-ordination across desks to improve collateral efficiency. Moving from a bilateral collateral model, which includes terms to minimise daily effort, to a daily VM and periodic IM model, will require changes to infrastructure and additional effort.
The views expressed herein are those of the author only and may not reflect the views of BNY Mellon. This does not constitute investment advice, or any other business, tax or legal advice, and should not be relied upon as such.
Paul North Head of Product Management EMEA, BNY Mellon
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