With the recent one year extensions to the regulatory deadlines, Initial Margin regulations have seemingly fallen to the bottom of the financial services market’s in-tray. Jorge Rey, a senior derivatives attorney with Factor, contends that the industry shouldn’t lose sight of the regulatory mandate given the challenges that remain in implementing the most complex elements of the Uncleared Margin Rules (UMR) regulations.
It would be easy to think that Initial Margin (IM) has been looming over the financial services industry for an eternity. Since the first wave came into effect in 2016, we’ve been on the slow march to the more arduous stages of the regulations for the bulk of the financial services industry, where hedge funds, pensions, asset managers, and smaller market participants fall into its scope and will soon encounter exchanging initial margin, using external custodians, and implementing new documentation for the first time.
We’ve had multiple reprieves on this journey. In July 2019, the International Organization of Securities Commissions (“IOSCO”) and the Basel Committee on Banking Supervision (“BCBS”) announced that the last phase of the implementation then scheduled for September 2020 (“Phase 5”), would be divided into two phases with the creation of a final phase, that would become effective September 1, 2021 (“Phase 6”). In April 2020, due to the disruption of the COVID-19 pandemic, the deadlines were pushed back one additional year to September 1, 2021 and September 1, 2022, respectively.
While the financial services industry is contending with multiple other priorities, it would be tempting to deprioritize IM in favor of other projects. However, it’s important to remember why the delays were necessary and to consider some of the issues that often protract IM negotiations.
There are several different challenges that broker-dealers and their counterparties must address in order to be ready to comply with the IM deadlines. It is vital to consider the dependencies across an entity’s internal organization: Front-Office, Risk, Operations, Collateral Management, Legal, and IT.
Our IM experience at Factor has taught us that internal readiness is a complex and time-consuming process. For example, ahead of negotiations, legal teams must prepare the required suite of IM documentation templates required to properly repaper existing credit support annexes or put new, reg-compliant IM contracts into place, and work with internal stakeholders to ensure the documents correctly reflect internal risk and operational practices. They must also devise the processes to handle internal escalations for non-standard terms requested by counterparties.
It is similarly crucial to consider the time necessary to work with external service providers. Since the IM rules mandate that initial margin be segregated with an independent third-party custodian, time will be required to find and work with the right institution. For instance, parties need to decide whether to set up a tri-party or a third-party arrangement with its custodian. Ample time is also required to set up the requisite custodial relationship agreements and custody accounts, as well as to complete KYC checks which can take several weeks. Another point to keep in mind is that custodians are imposing deadlines for readiness which are several months in advance of the official regulatory deadlines for each phase, warranting the need for an early start.
Equally critical is the proper resourcing of the team that will assist in negotiating the relevant IM documentation. At Factor, we’ve learned that it is vital to put teams into place early, as IM negotiations can easily take between 4-6 months to complete, with more complicated negotiations potentially extending up to 8 months. Though industry participants may devise IM agreement templates they would like to use, realistically, there will likely be material deviations in the common terms between the agreements of two counterparties which will require harmonization and the escalation of non-standard terms to the decision stakeholders of the respective parties. This portion of the negotiation takes the most time to successfully resolve. Having to compete for the attention of a broker-dealer for special terms as the deadline inches nearer and the number of counterparties that begin to focus on it markedly grows is all but certain to ensure that either the deadline will not be met and trading may be disrupted, or that IM documents may require further amendment down the road.
The negotiation process typically entails three phases that may each require a considerable dedication of time:
Some parties prefer to work through these phases concurrently, while other parties may opt to first negotiate IM collateral, followed by negotiating the ACA, and then concluding with negotiating the IM credit support document.
It is worth highlighting an important difference in IM negotiations from previous ISDA document negotiations: Perhaps for the first time, firms are not delegating tasks such as calculations, collateral movement, and operations to the dealer banks to manage. Instead, with some limited exceptions, the IM regulations generally require buy-side firms to perform these tasks themselves. This, in turn, means that dealer bank template contracts (which many buy-side firms are used to as a starting point for negotiation) are now less relevant than before since the buy-side is required not only to negotiate their own custodian contracts but also to ensure that their credit support documents reflect their own policies, systems, and operational requirements.
In relation to collateral, in the early phases of IM implementation, many market participants limited IM eligible collateral to high-quality liquid assets, such as G-5 to G-20 sovereign bonds with regulatory- compliant ratings and haircuts.
With smaller market participants coming into scope in Phase 5 and Phase 6, requests to include additional types of collateral, such as equities and corporate bonds, have increased. We should not underestimate the time required to negotiate the acceptance of non-standard types of collateral.
Internal approval escalations are a constant theme of IM negotiations, with dozens of counterparties competing for the attention of business approvers, resulting in significant delays in negotiation completion time.
In relation to custody documents, the new generation of IM-specific ACAs offered by custodians are far more efficient and industry-friendly than previous versions in that they limit the right of parties to comment on the agreements and require that parties select their elections in an appendix to the ACA.
However, there are still issues which the parties may need to resolve. For instance, a recurring issue that arises is where one party, as pledgor, affords the counterparty, as secured party, with dispute rights (also known as ‘notice to contest rights’), including a wait period before the pledgor can access its collateral where a pledgor rights event occurs. This example typically arises when a party takes the view that its applicable regulations require that it afford its counterparty with dispute rights. If such a right is absent in the ACA of its counterparty, the parties will have to negotiate how to address the asymmetry in rights.
The IM credit support agreements are similarly ripe with business terms which often require negotiation:
These issues are commonly negotiated between counterparties and, naturally, require escalation and approval by various stakeholders in both organizations, meaning that it takes time to achieve mutually acceptable terms. They create genuine commercial challenges and test the capacity of operating systems and procedures.
In terms of complexity, the work required in the area of IM falls at the most complex end of the scale and requires handling by the most senior (and most expensive) legal talent. However, given the volume of documents to be completed in a short time frame, other alternatives need to be considered.
In the best-case scenario, customers of the dealer banks would accept IM documents prepared with only minor or specific comments, but, as set out above, we know that there a number of difficult points that are often extensively negotiated and which protract the length of time required in order for the parties to reach an alignment of views. In Phase 6, in particular, we also have a slightly different challenge of explaining new concepts to market participants who are potentially seeing these points for the first time and who are navigating their own response to a complex process.
If senior resources with expert knowledge of the IM regulations and documentation are scarce and expensive, is there room to use more junior resources to staff legal documentation workstreams? The answer is yes, using a model in which Factor specializes and has leveraged successfully. The structure entails putting into in place negotiation guides or ‘playbooks’, template documentation, escalation and approval processes, and quality assurance checks. That, admittedly, is more involved than simply handing a pile of documents to a senior derivatives lawyer, but it pays dividends on large scale projects which demand a more structured response and a greater number of resources. In Factor’s model, junior negotiators work in a tight framework, with their work overseen by senior subject matter experts, including senior derivatives attorneys. The knowledge of the subject matter experts is collaboratively shared with the junior negotiators to allow them to tackle the more difficult negotiations themselves, with the end result being that the client is comfortable their goals are being achieved and their customers are receiving the service and attention they merit.
A further challenge for institutions and their customers is how to manage IM implementation projects with other regulatory obligations falling around the same timespan, such as LIBOR, the Securities Financing Transaction Regulation, EMIR Reft, Brexit, BRRD, and CSDR that all demand time, attention, and resourcing. Clearly, many institutions will need external assistance to supplement their existing teams, such as law firms, consultants, and alternative providers of legal services, such as Factor. Cost will be a major element, but the industry as a whole is developing more sophistication in its ability to combine different regulatory workstreams.
We know that credit support documents impacted by IM are also potentially in scope for EMIR Refit, Brexit, and LIBOR and that the challenge is whether firms can avoid having to separately open, review, and amend agreements for each individual compliance obligation. The more efficient model is to start reviewing and extracting data on one project which will likely be required on other projects. For example, if your EMIR Refit workstream requires you to open and review existing credit support annexes, can you use that opportunity to extract data, such as client contact details, for use on IM or to search to see whether a LIBOR rate is referenced in those agreements? If so, can that data be stored and shared later with other project groups, such as the LIBOR remediation team? And once you have that data, can you re-use it for future workstreams, such as business re-organizations and efficiency projects?
Though IOSCO and BCBS have extended the IM regulatory deadlines for Phase 5 and Phase 6 by one year, in-scope market participants should leverage the additional time to begin their IM negotiation preparations early, to avoid the inevitable rush on the market that will occur as the deadline grows nearer, in order to achieve compliance on a timely basis.
If IM has fallen to the bottom of your in-tray, now is the time to bring it back up and make it a priority. Get in touch to see how Factor can help.