On 5 March 2019, BCBS/IOSCO, the global standard setter for Uncleared Margin Rules (UMR), formally gave a moratorium that newly in-scope firms do not need to be operationally ready to exchange margin on 1 September if its Initial Margin (IM) amount is below the €50M threshold.[i] This means a firm could delay the hard work of opening segregated custodial accounts, negotiating legal paperwork and setting up a functioning margin workflow for as long it stays below the threshold. It was hailed as an effective relief as it provided firms with much needed extra time for preparation.

As we approach phase 6, the final phase of UMR in September 2022, an increasing number of firms see this relief as a permanent solution instead of a temporary relief. Some firms believe that their IM amounts can stay below the threshold indefinitely, and they should simply put an IM threshold monitoring solution in place and forget about the rest, at least for the time being.

But is it a failsafe approach? Even if a firm has a strong conviction that its IM amount will forever remain below the threshold, are there no pitfalls to be aware of?

Indeed, there are important elements to consider, namely:

• Contingency plan - what if the threshold is breached?
• How is threshold monitoring actually done?

Surely it is not a bad idea to permanently stay below the threshold - if feasible, that is. But not having a contingent plan to transition into a fully operational mode is too risky. In the unlikely event that the threshold is breached but the necessary operational set-up is not ready, the only choice left will be to halt trading. Very few firms would want to face this situation.

Can the threshold be breached unexpectedly?

In fact, the threshold may be breached more easily than one may think.

Firstly, the front office may trade a large trade if presented with an attractive opportunity. IM amount from a new exposure without risk offsets can routinely add margin in the region of 10-15% of the traded notional. It means that trades with an aggregated notional of €333-500M can produce a margin of €50M. This is not a very high hurdle notional amount.

Secondly, if the in-scope fund is separately managed, the actual threshold allocated to each investment manager may only be a fraction of the €50M. If equally divided between four, each investment manager will only be working against a €12.5M threshold. Since the threshold applies at the group level, it also needs to be divided between entities if multiple entities within a group are subject to UMR.

Thirdly, as with many other aspects of UMR, complications arise from having to simultaneously comply with multiple regulatory regimes. Specifically, the €50M threshold set by BCBS/IOSCO has been translated into equivalent amounts in other currencies such as USD 50M, CAD 75M, CHF 50M, JPY 7BN and HKD 375M. If a firm faces a counterparty regulated under a different jurisdiction than its own, the threshold level must be compliant under both. For example, if a Japanese firm trades with a US counterparty, the agreed threshold must be equal to or less than USD 50M and JPY 7BN at all times. But this is not a trivial issue as the exchange may fluctuate and it is difficult to dynamically alter the threshold in the IM CSA[ii]. In practice, a pragmatic approach may be taken - with guidance from the counterparty - to apply a conservative haircut to the threshold instead. Put simply, the $50M threshold may be reduced by, say, a 20% haircut to $40M as a defensive measure against adverse FX movements.

Lastly, many counterparties require newly in-scope firms to demonstrate that they are operationally ready not when they hit the threshold, but as soon as they hit the sub-threshold, which may be set as low as 50% of the threshold.

What is a good way to monitor IM threshold?

There are a few different ways to monitor IM. One way is to independently perform the same calculation as you would if margin had to be posted but simply monitor the results without moving collateral. Another approach is to simplify the calculation of margin amounts by, for instance, using the Grid (or Schedule IM) with a view to switching to SIMM if the threshold is breached. The third approach is to rely on the counterparty banks' calculation and monitor margin amounts passively.

In terms of ease of implementation, the first approach requires the most effort and the last one the least. The second approach - to use a simpler and different calculation methodology for monitoring purposes only - is a recipe for trouble. It is too risky to use an inconsistent calculation methodology for a small gain in ease of implementation.

So, the choice is between the first approach - an orthodox method to perform the right calculation independently - and the last approach of relying passively on counterparty calculation. There are a few points to consider:

• There is no overt regulatory scrutiny over details when a firm is simply monitoring because the firm is still not fully subject to the regulation (in light of the 5 May 2019 BCBS/IOSCO statement). But the moment the threshold is breached, the firm must be 100% ready.
• The effort required for putting in place a threshold monitoring solution is much reduced because third-party solutions are available.
• Independence is the central tenet of sound risk governance; leaving the task to the counterparty will delay uncovering important issues. For example, if IM is not independently monitored, hidden collateral disputes will be missed, and they will suddenly come to surface after the threshold is breached.
• Ultimately, each in-scope firm must take control of the margin process and have a governance framework that can withstand the scrutiny of its regulator. Firms cannot rely on counterparty banks for assistance, as they have limited bandwidth and their priority will always be on relationships that are actively exchanging margin.

Considering these, a prudent way to monitor IM amounts is to perform the necessary calculation independently without simply relying on counterparty calculations. By doing so, IM monitoring can be integrated into a sound risk governance framework, and contingency planning (for when the threshold is breached) will become seamless. In other words, taking the right step at the outset will save a firm a lot of unnecessary work in the future.

[i] BCBS/IOSCO statement: https://www.bis.org/press/p190305a.htm

[ii] Unless electronic documentation is adopted

Posted 11 November 2021 by Hiroshi Tanase, Executive Director, Product Analysis and Design, S&P Global Market Intelligence

S&P Global provides industry-leading data, software and technology platforms and managed services to tackle some of the most difficult challenges in financial markets. We help our customers better understand complicated markets, reduce risk, operate more efficiently and comply with financial regulation.

This article was published by S&P Global Market Intelligence and not by S&P Global Ratings, which is a separately managed division of S&P Global.