Variation Margin Requirements: The New Big Bang

As of March 1, 2017, a new set of rules will come into force that requires the vast majority of those capital markets firms that are trading derivatives to make subtle, yet significant changes to the way they post variation margins for non-cleared derivative trades.

It’s an event that some in the industry are referring to as the second “Big Bang”—the first took place in October 1986 when the London Stock Exchange introduced new rules that had far-reaching consequences for the capital markets and effectively ushered in the electronic trading era—due to the sheer scale of work that is required of derivatives-trading firms.

Under the upcoming variation margin framework, those entities that are within the scope of the new rules will be required to post variation margin on all new derivatives trades, both cleared and non-cleared, and collateralize the trades on a daily basis. Should a firm find itself unable to do so, it will be unable to trade these products going forward.

“The need to implement margin requirements came from the G20 initiative back in 2009 at the Pittsburgh meeting,” says Lars Overby, head of the European Banking Authority’s (EBA’s) credit, market and operational risk policy unit. “To reduce systemic risk, it was announced that margin requirements should be introduced on all derivatives so that you don’t get propagation of risk if one counterparty defaults, which has been an issue that we have seen in the past, especially during the financial crisis.”

Tight Timeframe

“To reduce systemic risk, it was announced that margin requirements should be introduced on all derivatives so that you don’t get propagation of risk if one counterparty defaults, which has been an issue that we have seen in the past, especially during the financial crisis.” Lars Overby, European Banking Authority

Similar to most regulations imposed on the capital markets in recent years, there has been a backlash against the timeframe in which firms have been expected to prepare for the upcoming variation margin requirements. Speaking at the Risk USA conference in New York in September last year, Scott O’Malia, CEO of the International Swaps and Derivatives Association (ISDA), warned that the implementation date was fast-approaching and that firms should have already begun work to prepare. 

Fast-forward to January 2017 and O’Malia tells Waters that while a tremendous amount of work has been done already, there is still some way to go. “I think people are, as we predicted, overwhelmed by the amount of work, and the number of documents and negotiations that have to go forward,” he says. “I do think everybody is working extraordinarily hard, working late nights or weekends, but the sheer scale of the task is going to make March 1 not the perfect outcome and that not everyone is going to be ready, as far as we can see.”

However, complaints from the industry over the timeframe for the adjustments to be made have been dismissed by regulators—specifically the European Supervisor Authorities (ESAs) comprising the European Banking Authority in London, the European Securities and Markets Authority (ESMA) in Paris, and the European Insurance and Occupational Pensions Authority in Frankfurt—which points to a clear and documented schedule, agreed at an international level.

“The ESAs have been very clear that this was the timeline the industry should expect,” says Overby. “It’s not something for which the industry has not had the time to prepare, given that the work has been under way in the EU since 2012. The industry has known all along that this was coming. We all understand that there are technical issues that require solutions to be found, but it is not something that can come as a surprise to the industry at this stage, especially given that the majority of the market already exchanges variation margin. So it is a practice that is widespread already in the industry today.”

According to Fabrizio Planta, head of ESMA’s post-trade unit, there was a delay to the development and publication of the variation margin technical standards in Europe, due to an overlap with the development of the international standards.

“We first waited for the finalization of the international standard, but also agreed on an international calendar, and that is aligned,” Planta explains. “It was already quite an achievement for the international community of regulators to agree on a single calendar, and that was also for the benefit of the industry, so there would be no regulatory arbitrage. The industry can prepare for the same dates and have the international standards agreed on how to process this.”

Unlike the implementation of Mifid II in Europe, which has been subject to a one-year delay, Overby says any hopes of a similar postponement to the variation margin requirements will be futile, while Planta says the issue is only of concern to the industry now because the implementation date is drawing near. “It’s true that in Europe the exact date was known only after the publication in the official journal, but, again, the ESAs published our standards and it was known that we were respecting the international agreement,” he says. “It’s the last chance the industry has to complain. The industry says we only published the requirements a few months ago, but this date was known for the last two years.”

Huge Challenge

Historically, variation margins for cleared derivatives have been calculated and posted by counterparties on a voluntary basis. Under the new rules, that will become mandatory for almost all market participants. While some of the smallest players are exempt from the ruling, however, this does differ between regional jurisdictions.

“Most derivatives users certainly posted variation margin before and you hear this refrain from regulators: ‘How hard can it be? This is something you are doing already.’ The concept of variation margin is not the challenge here—it is the execution and the transition, because it is a new ruleset and of course everybody is striving to be compliant,” says ISDA’s O’Malia.

He says it is not so much the actual posting of variation margins or the calculation of the required collateral that the industry has so far struggled with, but rather the wider implications that the new rules will have across internal operations, particularly for the smaller participants that are expected to comply. The scale of the task put to the industry when it comes to the new variation margin

requirements is most evident in the documentation work that must be undertaken. The collateral agreements made bilaterally between the two counterparties of each non-cleared derivatives trade, known as credit support annexes (CSAs), must be amended to reflect the new requirements. It is a massive re-papering and negotiation exercise for the industry, particularly for larger institutional banks, which have tens of thousands of such documents. 

“The biggest challenge is laying hands on every single document, assessing what is in compliance and what is not compliant,” says O’Malia. “There are a variety of tools available, but ISDA can’t do that job for them. The counterparties have to have a negotiation, to sit down and work through to update those documents. That takes time; that takes people. There’s not a machine or an app for that, so it is a tedious process that’s going to involve lawyers and the front office to make sure everyone is aligned.”

ISDA has worked with organizations across the industry on the documentation issue, offering a variation margin protocol that will enable firms to amend the relevant documentation or set up new agreements in compliance with these requirements. The idea is to eliminate most of the manual processes involved and cut out the negotiations otherwise required.

Bigger Picture

While the documentation aspect is taking up much of the industry’s attention, Neil Wright, managing principal at consultancy DerivProduct and industry advisor to technology consultancy Sapient Global Markets, believes that the documentation exercise is a “huge task,” and that certain firms are failing to see the bigger picture by focusing solely on just one aspect of the new rules.

“There are a number of operational implications that are really quite significant, and to my mind, these don’t get the attention they should,” he says. “Having to move the collateral on the actual day that the collateral is agreed, for example, is a huge impact on operations staff and there are a lot faster processing times required there.”

Lee McCormack, head of strategy and product development at collateral management vendor CloudMargin, also highlights the increased burden that operations staff will have to deal with under the new variation margin rules, particularly concerning collateral calculation processes.

While larger institutions have the scale to handle the workload burden, McCormack says some firms, particularly those on the buy side, may struggle to cope, even those with the resources to throw more bodies at the problem. “The operational processes that those guys are facing will go through the roof,” he says. “They can throw more operations resources at the problem, but it is still subject to significant other operational risk and the regulators are very hot on that.”

Meanwhile, there will be a number of smaller firms—again mostly on the buy side, that lack both the human and financial resources to deal with the requirements internally—that will opt to outsource that work to a larger entity more capable of handling the volume of work required, or else implement a new collateral management solution.

“In this environment where there are lots of other compliance costs, firms are reluctant to do that if there is a solution out there that absolutely meets their needs—functional, easy to implement, and cost-effective,” says McCormack. “A software-as-a-service (SaaS) solution is absolutely perfect for what these firms are going to need. “

Technology Reliance

While many of the various regulations introduced to the market in recent years have been aimed at cutting out manual processes as much as possible, or at least reducing the errors to which they are linked, the variation margin requirements are not directly seeking to introduce greater automation through technology.

The EBA’s Overby says that unlike other regulations, such as Mifid II, which include detailed technical standards on trading technologies, regulators have not taken this approach for the implementation of the new variation margin requirements.

“On the technology aspect, this is a business decision,” he explains. “The ESAs have been deliberately silent on this from the regulatory side. We’ve given the industry the choice of how to implement this in the systems, and whether they want to rely on technology providers or whether they want to develop it themselves.”

As firms have been left to their own decisions on how to handle the new demands on variation margins, there is also an onus placed on the technology and service providers in this space to invest in new and enhanced technologies to cope with their clients’ demands.

“This is not an issue where there is a standard answer for every question, because every firm is in a different stage,” says Wright. “A lot of firms are using in-house solutions, a lot are outsourcing, and a lot are using service providers. I think the service providers have some challenges as well, because they have to update their platforms based on getting the information from their clients, so they have to update the agreements to reflect what their clients have agreed with their counterparties, and then they have to update their systems.”

While some firms scramble to implement new solutions prior to the deadline, the industry in a wider sense is still relying on more traditional means to address the new variation margin rules.

As ISDA’s O’Malia puts it, there is still much work to be done. “A lot of people give us the anecdote that the cutting-edge technology for collateral management today is Excel spreadsheets and Outlook,” he says “The desire to automate and streamline the whole process really needs a 21st century upgrade and we’ve been talking to our members about what that is going to entail. It’s a work in progress. I can’t say how that’s going to end or when it’s going to end, but from the feedback we get from our members, it is something that is a priority.” 

Salient Points

• The new variation margin requirements come into effect on March 1, 2017, and will impact all new cleared and non-cleared derivatives trades; all firms are now eligible to post variation margins and collateralize each trade on a daily basis.
• While some firms have been doing this already, the majority of the market is under pressure to find ways to ease the operational burden the new requirements will put on collateral calculations and management operations.
• The majority of the work undertaken so far has focused on credit support annexes, and while it is a complicated task, it is a one-off exercise.
• Many firms across the industry will be seeking new technology solutions to ease burdens on collateral management operations, although some will not have the resources to do so and may be forced to continue to rely on Microsoft Excel spreadsheets despite the increased operational burdens.