The changing face of OTC derivatives trading

Concerns over many buy-side firms’ readiness to meet new margin requirements governing trading in uncleared, or bilateral, over-the-counter (OTC) derivatives have recently led regulators to push back the timescales involved.

Under the new rules, banks, hedge funds, pension funds and asset managers must introduce operational processes and systems to handle margin requirements - the posting of collateral with a third party - for all their bi-lateral derivative deals. This involves calculating the amount of collateral they must post against these trades - the margin - and then posting that collateral with a segregated third party custodian before settling the transaction.

However, smaller firms with aggregate notional amounts of between €8 and 50 billion in uncleared OTC trades have now been granted an extra year of grace - until 2021 - to ensure they are fully compliant.

The new OTC rules are part of the European Market Infrastructure Regulation (EMIR), which was introduced in response to the last financial crisis in a bid to improve derivative trading transparency and reduce risk for participants. EMIR also includes requirements on reporting derivative trades and the mandatory clearing of larger derivative trades.

According to the International Swaps and Derivatives Association (ISDA), about 300 entities will now be affected in 2020 when the threshold falls to €50 billion, as opposed to around 1,100 entities that would have been hit had the threshold remained at €8 billion for next year.

This is expected to result in a softer landing for smaller buy-side firms, although many have yet to take the steps needed to ensure compliance.

“There is still a lot of panic now in relation to the 2020 deadline, as in a number of organisations a lot of work is still needed,” said Helen Nicol, the product director at Lombard Risk responsible for its COLLINE by VERMEG solution. “However, the scope required to meet this year’s threshold is already in place in most organisations and they are now conducting tests.”

Edel Brody, global regulatory compliance manager at Fenergo, whose regulatory compliance platform supports implementation of the new OTC rules, explained: “The new regime will have implications for all firms’ front to back-end processes, leading them to consider their operational efficiencies – there are huge implications in getting firms up to speed.”

At present, firms with an aggregate notional amount of more than €1.5 billion in uncleared OTC trades already have to comply with the requirements, and this threshold falls to €750 billion in September this year as planned.

Mark Higgins, senior product manager for clearing and collateral management at BNY Mellon, pointed out that this year’s threshold is most likely to impact banks and some of the largest hedge funds, but “the actual number of entities involved may vary as the newly in-scope banks could have affiliates that will be affected”.

He added: “Next year, we will see asset managers, more hedge funds and insurance companies caught by the new rules, while the lowering of the threshold to €8 billion will see them applied more to smaller entities.”
In terms of being systems-ready, buy-side firms can do all the work needed themselves in-house; invest in a collateral management solution that offers the capability to handle OTC margin requirements; or use the services of a third party.

BNY Mellon recently announced a partnership with ArcadiaSoft that will enable firms to fully outsource their non-cleared derivatives workflow and meet their obligations in one place. Firms using its existing bilateral margin capabilities, which include collateral segregation and ongoing position monitoring, can now access AcadiaSoft's suite of tools for margin calculation, reconciliation and messaging.

VERMEG’s COLLINE solution, meanwhile, supports all regulatory collateral needs - not just OTC derivatives - and provides transparency into all of a company’s assets that can be used as collateral. The integrated, modular system, which supports OTC trade compliance, can be hosted or delivered using the software-as-a-service model.

“Where they have an existing collateral management solution in place, they may opt for add-ons,” said Nicol. “Our OTC solution does all the necessary calculations to assess the amount of collateral needed; advises on what is eligible as collateral; ensures margin calls are responded to; posts the collateral and then handles settlement with the custodian or tri-party agreement used – this is then followed by reporting.”

While the new OTC margin rules are expected to force firms using OTC derivatives to post huge amounts of capital with third party custodians, there are ways in which they can ensure this sum is kept to a minimum.

“There are options for entities caught by the thresholds to improve efficiencies to deal with the rules, such as clearing more of their OTC derivatives instead of trading them bilaterally,” noted Higgins. “When it comes to the €8 billion threshold, some smaller entities may start tracking their trading positions in order to make decisions on moving more volume into clearing.”

Derivatives analytics firm OpenGamma, offers a Standard Initial Margin Model product which calculates initial margins daily, validates and reconciles margin calls and advises on trading moves that can reduce initial margin requirements.

Chief operating officer Maxime Jeanniard du Dot explained that using derivative analytics can help financial firms make better trading decisions and reduce initial margin costs from 5.5 per cent for banks to up to 70 per cent for hedge funds.

“The growth of our company will depend on how the market evolves as well as how it changes – and this will call for new ways of doing business,” he said. “We are now looking to launch a new product that our existing clients can leverage to drive capital efficiency pre-execution.”

With OTC derivative margin rules expected to change on an ongoing basis, specialist solution providers are likely to offer a viable alternative to in-house development.

“There may be a lower degree of lag for companies working with tech vendors should any changes to the OTC margin rules ever be made,” pointed out Higgins. “These vendors can help to enable an orderly transition by working in advance.”

Nicol added: “Changing regulation is always going to present a challenge, so solutions offered as a package put the onus on the provider to keep up with any changes to the regulation.”

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