Samuel Hyman, Head of Americas, Cassini Systems
If you trade bilateral OTC derivatives then you probably know by now that the Uncleared Margin Rules (UMR) are rapidly approaching and will require significant changes to your trading, book management and collateral management processes.
The industry has produced plenty of information about how to manage the operational changes that UMR require, but here we want to bring attention to the more important problem of how to minimize the impact of UMR on your investment portfolios. We’ll look at three key capabilities you need from any Standard Initial Margin Model (SIMM) solution you implement.
Quick recap, Phase 4 kicks in as of 1 September 2019, and covers firms with over US$750 Billion in outstanding derivatives exposure, then phase 5 requires all remaining firms with over US$8 Billion of derivatives exposure to be compliant by 1 September 2020.
Compliance at a minimum requires calculating and exchanging initial two-way margin on all uncleared OTC trades, with an additional caveat that if the initial margin (IM) requirement is under US$50m (on a group relationship basis) then no actual collateral needs to be posted.
The net result is that bilateral OTC trades become more operationally complex and require both sides of each agreement to daily calculate IM on the portfolio. But more important is the drag on portfolio returns that is created by the very significant amount of new collateral (whether cash or other assets) that will have to be posted.
While UMR compliance is mandatory, the BCBS/IOSCO rules don’t specify the actual IM methodology so ISDA, working with the main industry participants, has defined a standard methodology, the SIMM™ methodology, to simplify calculation and agreement of IM requirements. The UMR also defined a simple grid-based approach for firms to use if they didn’t want to implement a more lenient risk-based model. The Standard Grid is generally much more punitive on initial margin so is generally to be avoided.
As you start to plan your operational changes, selecting the right technology solution for your SIMM calculation is critical and your selected systems need to support two equally important requirements:
- Calculate the SIMM requirement (both Post and Call amounts) for the end of day collateral management process
- Give you the tools to manage and reduce the overall funding impact caused by the new collateral requirements.
If you are a firm that will be in scope but are able to stay under the US$50m threshold for posting margin, then the tools mentioned in b) are even more important. You need to actively manage your margin levels to ensure you don’t accidentally fall into scope.
Here, we discuss the three key criteria you should consider when choosing which SIMM provider to partner with.
- Will it help you understand current and future funding impact?
The biggest change UMR will bring is the need to post initial margin on uncleared trades. This creates operational issues, as has been much discussed, but also liquidity and funding challenges that impact the overall trading profile.
As ISDA note in their July 2018 discussion paper1, one of the main consequences of the UMR is that demand for collateral is set to rise significantly. As a result, cash previously used for trading activity will now be tied up as collateral. This creates drag on the portfolio and therefore impacts your future trading decisions.
How should firms plan to understand and manage this funding impact? The first step is to begin calculating future SIMM margin requirements on existing portfolios. This enables institutions to have a clear view on which funds are going to post margin, and the relative impact on each.
Of course, the rules only apply to new trades, all existing open trades can be kept under a legacy UMR and avoid IM, although that will not always be the best choice,
Additionally, by forecasting IM requirements over time and testing different strategies to optimize IM, buy-side firms can adapt trading strategies in preparation for 2020. Strategically thinking about, and planning for, future funding and liquidity changes allows firms to better prepare for the impact of the forthcoming regulation.
More to the point, being able to look at the broader picture makes for better funding, risk and liquidity decisions and – ultimately – for better performance.
So, your chosen SIMM solution needs to provide tools to test and forecast SIMM impact across your books, and help you find the best outcomes.
- Can it generate sensitivities intra-day?
Calculating bilateral margin with SIMM firstly requires the calculation of risk sensitivities for all trades in the portfolio. At first glance firms may take the view that they can generate the risk sensitivities from their various existing risk processes and desks. However, this is not as simple as it seems.
Firstly, the current in-house risk models may not match the models and assumptions defined under SIMM. Additionally, for firms with multiple trading desks there is the challenge of ensuring consistent risk models and market data are used across all desks.
Then the various risks need to be generated, converted into the CRIF (Common Risk Interchange Format) format, and collated at firm level.
Side note: with very bespoke trades it may be easier to margin using the Standard Grid model rather than SIMM, due to the complexity of agreeing risk models and market data, but this will need to be agreed by both sides when setting up the new agreements. The agreement would then support two netting sets, one margined under SIMM and one under Standard Grid.
Given the above challenges most buy-side firms are now electing to use a third-party provider to generate sensitivities, and these use their own market data sources. However, with more complex portfolios you will have specific situations where you need to provide your market data to the SIMM calculator so make sure that is also supported.
So, you need to ensure your SIMM solution provides sensitivity calculation, supports the Grid model, and allows you to override market data or sensitivities on outlier trades.
- Can it run intra-day monitoring and provide what-if tools to optimize portfolio margins?
While any SIMM solution will calculate the end of day post and call requirements, it is essential that you have tools to better understand the impact of new trades, for the following reasons:
Firstly, the best time to optimize the impact on your portfolio is pre-trade. Where end-of-day calculations show your position after the fact, pre-trade calculations help you understand what specific trades will cost before you go to market, enabling the portfolio manager or trader to select trades that have the best price and the least impact on your portfolio.
Having pre-trade visibility on margin impact will a) allow you to trade more cost-effectively, but also b) provide tangible proof of best execution that complies with the “all sufficient steps” requirement of MiFID II2.
At the same time, running margin calculations intra-day gives you a better view of the bigger picture.
- Intra-day SIMM calculation allows you to track your overall exposure throughout the day ensuring more transparency and the ability to get in front of any funding or collateral issues.
- Portfolio optimization tools also allow you to identify opportunities to novate legacy trades into the SIMM portfolio to offset margin, or to rebalance risk across your agreements, taking the US$50m threshold into account to minimize the net margin requirements.
So finally, your SIMM solution also needs to give you intra-day transparency, pre-trade testing, and what-if tools to actively manage and reduce your margin requirements.
Calculate. Analyze. Reduce.
The way you trade OTC derivatives is changing. But while this will undoubtedly create new funding, liquidity, and operational challenges, choosing the right SIMM software and tools can help you approach them more strategically, minimize their impact and, ultimately, optimize your portfolio to get the best performance possible. n
Footnotes:
- https://www.isda.org/a/D6fEE/ISDA-SIFMA-Initial-Margin-Phase-in-White-Paper-July-2018.pdf
- https://www.esma.europa.eu/policy-rules/mifid-ii-and-mifir
Want to find out more?
Cassini’s SIMM platform can help you calculate, analyze and optimize your margin requirements pre-trade, intra-day and end-of-day. You also choose whether you deploy the SIMM platform on your premises or use a dedicated AWS hosted solution. Get in touch for more information.
Email: Shyman@cassinisystems.com
Landline: +1 646-975-2155
