Turning up the heat – the Margin Phase 6 legal log-jam

Feeling the heat? It might not just be that summer is upon us. With only 79 days to go until the Initial Margin (IM) Phase 6 deadline on 1 September, things are hotting-up in the legal documents space too.

Does this affect me?

If you are a Financial Counterparty (or Non-Financial Counterparty above clearing threshold) that trades bilateral derivatives (other than deliverable FX forwards) then you need to establish whether you are in scope of the rules (> €8bn Average Aggregate Notional Amount, or AANA), and if yes whether you might be anywhere near breaching the €50m collateral threshold with any counterparty, meaning you have to exchange IM. 

And if ‘yes’ to that then get IM docs and custodian arrangements in place. Even if ‘no’ to the second question, you still need to monitor your exposure and agree with your counterparties the level at which you would cease trading (until IM docs are put in place). If ‘no’ to all of the above, relax and get back to your sun lounger.

For more detail on the ins and the outs of IM, how you measure thresholds, what docs have to be signed etc, see ISDA’s Margin InfoHub (complete with doomsday countdown clock!), the Phase 6 Countdown post and Scott O’Malia’s Last Chance article flagging only 6 months left (now only 3!).

The Legal Log-Jam

With an estimated 775 new counterparties in scope, 5,400 relationships potentially to be documented (ISDA), and less than 3 months to go, there just aren’t enough lawyers in the world (didn’t expect to ever say that!) to get all the negotiations finished on time. We are seeing strains in the market as people scramble to get the work done.

With average length of time to negotiate IM docs of 3-4 months, it is already too late for many. The custodian BNY Mellon has set cut-off dates which are now past in many cases for submission of relevant docs such as Account Control Agreements in order to be ready for 1 Sep (see BNY Mellon hub page). So even with docs negotiated, the ops setup will be a challenge with everyone knocking at the door of the same small number of custodians.

The situation is compounded by the lack of clarity in the market of who is in scope of Phase 6 and who isn’t. The last AANA period (see above and ISDA) closed at the end of May 2022, so there are no more excuses not to make a declaration of whether you are in excess of the €8bn threshold for derivatives during the year. The disclosure can be made via Markit or bi-laterally. By the way, if you haven’t told us yet, please contact our mailbox margin.documentation@natwestmarkets.com to liaise with our IM team. 

In practical terms, this crunch on time and resources means market participants are having to make priority calls on which of their counterparties to focus their limited capacity in the near term. That in turn is placing more reliance on the Threshold Monitoring approach. 

Monitoring Thresholds

Threshold Monitoring (TM) was previously thought of as a very welcome safety net where documents were not yet in place (in fact we wrote an article, Small Margin for Error, back on Phase 5 go live in 2021 making this point). The regulatory obligation to post or receive initial margin only kicks in when you breach a threshold of €50m between two entities.

So, many that were thinking they would get nowhere near this level were happy to save the time and money on full IM repapering, and instead just watch the daily Standard Initial Margin Model (SIMM) numbers. Then only take action (to repaper) if they cross some mutually agreed % of the redline threshold.

The problem with this approach is that in volatile markets positions can swing around to a greater degree and much faster than perhaps people have been accustomed to, meaning you can suddenly be left with an urgent need to reduce exposure to avoid cease trading mandates and regulatory breaches. In general in current market conditions many are taking a much more robust approach to threshold monitoring (i.e. setting low % thresholds for triggers), thus placing further strains on the legal doc process.

Wrapping up – what are my next steps?

In summary, with the 1 September date looming, you should:

1.      Make your Phase 6 disclosure if you haven’t already

2.      Assess which counterparties matter most to you in terms of exposure and ongoing trading, and prioritise them for 1 Sep

3.      Keep on top of negotiations with counterparties and engagement with custodians; push for progress now, the field is only going to get more crowded

4.      Don’t assume Threshold Monitoring is the panacea, but do make sure any TM processes you rely upon are robust

On another note, SA-CCR

Not specifically related to IM, however another regulatory driver creating an impact to derivatives trading in the market is SA-CCR (Standardised Approach to Counterparty Credit Risk), first consulted upon by the Basel Committee back in 2014, but finally starting to be introduced under Basel III roll-out depending upon jurisdiction from January 2022. The SA-CCR rules can penalise banks more than previously for holding uncollateralised or non-cash collateralised FX forward positions, especially where there is directional risk.

The new SA-CCR rules impact RWA calculations and therefore capital requirements for banks, although they are impacting different banks in different ways, depending upon jurisdiction (UK/EU v US) and business mix, but it is beginning to feed through to pricing and spreads in some scenarios.

It means there will be greater focus on mitigation activities by banks, e.g. multi-lateral optimisation exercises using third parties such as TriOptima. And expect SA-CCR considerations to start to influence pricing more at a counterparty or transaction level. There is also some lobbying underway calling for a more holistic review of the SA-CCR regime (see ISDA / GFMA letter to BCBS in Apr 2022).

In conclusion, recent SA-CCR developments may give UK/EU banks an edge over their US rivals in certain scenarios, e.g. some FX Forwards portfolios with corporate clients, due to slightly different capital treatment in their respective jurisdictions.

Sector regulations

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