At Asia Risk Live, held in Singapore in March, and in partnership with S&P Global Market Intelligence, three market experts discussed the outstanding challenges associated with implementing and adhering to uncleared margin rules (UMR) phases five and six
At the 2009 Group of 20 Pittsburgh Summit, in the aftermath of the global financial crisis that began in 2007–08, G20 heads of state and government crafted a mandate to reduce risk and improve transparency within global financial markets. A raft of new rules and regulations were then imposed. Among several other policy initiatives, the G20 agreed to a financial regulatory reform agenda for the over-the-counter derivatives market, including recommendations for the implementation of margin requirements for non-centrally cleared derivatives.
Subsequently, the Basel Committee on Bank Supervision and the International Organization of Securities Commissions finalised their framework on Margin requirements for non-centrally cleared derivatives, which sought to establish international standards for such requirements, to be phased in over time. As part of these reform packages, UMR began to be phased in from September 1, 2016. Relatively few firms were affected by the early phases, but by September 2022, it is estimated more than 1,000 additional institutions will be subject to UMR for initial margin (IM), raising significant challenges to all firms involved, which were discussed and analysed by the Asia Risk Live panel in Singapore.
Outstanding pain points for in-scope firms
Given the breadth and depth of the challenges to be dealt with by firms affected by UMR phase five (with the IM compliance date being September 1, 2021), the scale of work involved in adhering to these regulatory standards and then to the standards of UMR phase six (for which the IM compliance date is September 1, 2022) is enormous.
“One of the things you will find from meeting the UMR regulations is that you’ve got to rethink your entire end-to-end flow, operational processes, and so on. So ‘business as usual’, as we at OCBC saw it, had to change,” said Frederick Shen, senior adviser, global treasury at OCBC Bank. “The reason is due to the nature of the UMR regulation itself, which many may think just applies to banks and other large institutions but actually doesn’t just apply to those.”
OCBC Group’s case is a prime example of how new UMR regulations significantly impact day-to-day handling of non-cleared derivatives transactions – specifically in the treatment of what might be regarded as individual business operations for trading and collateral purposes.
“In practical terms, it could be said that OCBC Group consists of several entities: there is OCBC Bank, then there is the private bank – the Bank of Singapore [BoS] – and then there is Lion Global, which is the asset management arm of OCBC Group. Normally, it might be expected that Lion Global – given its size – would not have been caught in UMR if it was a standalone entity but, because it was part of OCBC Group, it is caught. The same applies to Great Eastern, the insurance arm of OCBC Group,” Shen said.
This association of apparently separate business operations into effectively one business – as far as the application of UMR is concerned – meant OCBC had to rethink how the operational flows of OCBC Group would be affected. This was particularly the case in terms of optimising OCBC Group’s collateral and optimising the threshold limit given to OCBC Group before it must post collateral.
“That limit for the group is a total of $50 million, so we had to work out how it should be allocated across all our business units. The way we have done this is to decide on a single street-facing entity, which is OCBC Bank – and it is that OCBC Bank entity that faces the street to all counterparties,” Shen said.
Why the operational framework must deviate from previous phases
The operational difficulties inherent in such a situation are exacerbated for firms that do not have the ability to leverage from a significant parent – as is the case for OCBC – particularly on the buy side, said Sage Patel, managing director for pricing, valuations and reference data, Asia‑Pacific at S&P Global Market Intelligence.
“There are many vendors and service providers in this space. But having the ultimate ability to capture the entire workload from pre-trade analysis, pre-trade review and more, to give a sense of what that the margin will look like, plus a workflow that handles collateral posting, to reconciliation, to managing your valuations and data, is a significant challenge,” he said. “Data is now oxygen because it is fuelling the validation of the valuations that come through.”
For OCBC, the single street-facing entity approach allows the group to manage its trading and collateral correctly, according to Shen. “Only by doing it that way can we capture all of the transactions that impact the group. Only that way can we know if the group itself has exceeded the $50 million limit under the Simm [standard initial margin model] for posting of collateral, and only that way can we manage how we optimise our collateral for OCBC Group,” he said. “So that was the big change that had to occur at OCBC in order to make UMR a reality.”
The advantages of operating with a single street-facing entity were also evident to Christophe Mayol, head of derivatives at AIA Investment Management. Speaking on the experience of AIA Investment Management – which operates across 18 different jurisdictions – Mayol said: “The single street-facing entity is the route we have taken as we have to deal with 18 entities in 18 jurisdictions, and there is a huge operational burden that comes with that and change management.”
Yet, even with this system in place, differing interpretations of regulators in various countries add to the difficulties in managing collateral in the required way. “If OCBC does an interest rate swap – for example, with our own BoS – it is treated just like any other interest rate swap: we send them a confirmation, get them to post variation margin and all those things. OCBC then does the legwork with any counterparty – Standard Chartered, for example – and exchanges the cashflows. Basically, BoS would use OCBC bank as a flow-through,” said Shen.
“Unfortunately, the regulations are all intertwined: it might seem that there would be no impact from the UMR for this deal because BoS is a fully owned subsidiary of OCBC Group, but the MAS [Monetary Authority of Singapore] has the large exposure rule MAS Notice 656, and this says OCBC has an exposure to BoS that is subject to that rule,” he added. “This says we cannot have more than 25% of our Tier 1 capital exposed to a single counterparty group – therefore adjustments to our model have been made,” he underlined.
Utilising local securities and government bonds to meet collateral requirements
The organisational complexity arising from UMR phases five and six is compounded by the wide variation of collateral offered by, and acceptable to, the various trading counterparties. OCBC Group has had to reassess both its collateral processes and how it manages collateral. “Previously, traders have treated posting the margins as a freebie – it didn’t come into the cost of their swap – and now UMR changes all of that. So now, as the first part of the negotiations with counterparties, we have to ask: what is the set of collateral that you will accept? And every bank is different,’’ said Shen.
“Japanese banks want to post Japanese yen or yen securities [with us], European banks wants to do likewise with the euro, and so on, but we’re a Singapore bank – we have a lot of Singapore government securities and a lot of US Treasuries, and that’s what we like to post. So how do we manage that?” he added. “This is why OCBC Treasury also set up a global collateral desk managed out of Singapore. Basically everything goes through this desk, and they have insight into what the margins are and how close we are to the threshold.”
The wide disparity between what type of assets or securities are wanted by various counterparties – as well as the currencies in which they are denominated – cannot always be done within the four walls of every financial institution, said Shen.
“When you think of the Simm calculation that comes from that – which ultimately drives the collateral call – it shows how fundamental that all is to this process. And the importance of having an efficient [and] well-resourced workflow in there, and one that is accessible to the entire group – affiliates and partner organisations – is crucial,” he said.
Before the UMR phase five September 1, 2021 deadline, OCBC examined its top 20 counterparty banks, considering the necessity of negotiating collateral agreements, with the result that many of its counterparty banks were put on ‘threshold monitoring’. This allows for the negotiation of collateral requirements – including what assets and securities are acceptable, and the exchange of custodian information – at the point they exceed a particular threshold.
As an adjunct to this process, OCBC’s global collateral desk factors in the price of collateral and variation margin into all of the group’s contracts, whether they are done by Great Eastern, BoS or OCBC Bank, including the valuation adjustments component.
Addressing operational challenges with cross‑border security exchanges
A corollary of this international mix of counterparties is the broader operational difficulty of managing trading and collateral across borders, highlighted Shen.
“Take [the example of] a top counterparty with OCBC. I won’t tell you which bank, but it’s obviously one of the global banks – we exceeded the $50 million threshold within the first three months from UMR phase five kicking in on September 1, 2021. Don’t forget there was a clean slate starting at zero from that date, so we had to start posting margins and then we had to start charging collateral,” he said.
“But we must not be overly theoretical as to whether we should charge collateral based on the marginal impact or who did the deal that crossed the threshold, because then you encourage a sort of theoretical game-playing exercise by dealers rather than them doing their jobs properly,” he said. “In this context, we need to remember that OCBC Group also has subsidiaries in Malaysia, Indonesia, Hong Kong/China, in addition to BoS and Great Eastern, and so we don’t want to be too theoretical or overanalytical in how we charge margins and collateral out to our in-house subsidiaries,” he underlined.
This said, the challenges to remaining on the right side of all the UMR phases going forward have intensified. “Firms now have scrutiny on them, not just from their internal audit and compliance offices but also from the regulators looking at them in a very proactive way,” Patel noted. “This will influence their investment decisions and how their customers are going to perceive them, so from that whole spectrum there are multiple reasons for them to get it right.”