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ROCKET EDITION 9 | SPRING 2017 www.theotcspace.com

The Magazine From The OTC Space | News, Articles and Opinion on the Capital Markets

Chaos on March 1st l Liquidity Risk l The Silent Assassin l

The Collateral Cliff Edge l Hope and Change 2.0

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EditorialRocket • Edition 9 | Spring 2017 • theotcspace.com | 1

A s I write this there is a sense of impending chaos in the bilateral un-cleared OTC market. Feedback from all sources suggests that the industry isn’t anywhere near ready for the March 1st requirement to exchange variation margin. By some measures less than

10% of the required agreements have been put in place, although whether those 10% represent 50% of the market isn’t clear.

Why has such a mismatch occurred between the regulatory requirements and the ability of firms to comply? The nature of the margin agreements has been public in draft form since 2013 and revised since, and then in final form by ESMA since March 2016. An outside would say that the industry has had plenty of time to anticipate this requirement and be ready. So what’s gone wrong?

Feedback suggests that firms just didn’t get started early enough and underestimated the work to get ready. Given the structure of the OTC market with the buy-side relying on a small number of sell-side firms to provide execution, this concentrates activity for the major dealers who will prioritise their work to suit their own needs.

It was hoped that an ISDA Protocol enabling firms to leap the CSA hurdle quickly would be a major part of the solution. Expectations were that between 60 to 80% of agreements could be implemented this way, the outcome is nearer to 20%. Firms are insisting on negotiating terms to their preferences meaning each agreement needs far more work by both parties to finalise.

The trend now is to amend existing agreements to make them compliant rather than adopt any set of standards, the result is that as of writing in early February there isn’t enough time for firms to be ready. There isn’t enough people power to accelerate the current approach, so the industry is faced with uncertainty and the realisation that this process will continue for months afterwards.

Pleas to regulators for more time have not resulted in any change to the approach – although regulators in Asia have adopted a six month transition period. What can a firm do?

Step 1: All hands to the pumps. Get anyone who can possibly be spared talking to clients with a ‘going in’ CSA as a default. Give them a guideline on what is allowable and try to get a CSA in place.

Impending chaos

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The OTC Space News, Articles and Opinion

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EDITION 9 | SPRING 2017

EditorialRocket • Edition 9 | Spring 2017 • theotcspace.com | 2

Step 2: Decide internally what your policy is for March 1st. Do you keep trading whilst outside compliance? Do you cease trading until a CSA is in place? Do you know the answers to these questions from your countparties?

Step 3: Prioritise the agreements, using relationship value, revenue, size, risk, whichever criteria makes the most sense.

Step 4: Consider an interim ‘fallback’ CSA with compliant terms which are economically viable for both parties whilst the final CSA is being negotiated.

Once the dust has settled what will be the longer term impact on the uncleared OTC market? Will it be a dramatic reduction in the use of non-vanilla products? Will the market shrink and move to exchange traded products? No doubt the data flowing from the US Swap Data Repositories will give a good indication within a few days.

Bill Hodgson Owner and editorMarch 2017

Bill Hodgson has worked in the capital markets for more than 20 years on key pieces of market infrastructure. We are always looking for articles, get in touch if you have something to say to our audience.

E [email protected] @theotcspaceW theotcspace.com

ContentsRocket • Edition 9 | Spring 2017 • theotcspace.com | 3

Regulatory Horizon: Hope and Change Version 2.0by James Parascandola

Contributors

Get Ready – A $13 billion Collateral Headache is Heading in Your Directionby Peter Farley

Buyside Challenges: start of a seismic shift to a new era?by John Lund

The Collateral Cliff Edge – Variation Margin on the Brinkby Phil Langton

Margin Requirements for Uncleared Derivatives Updateby Nick Stafford

7

4

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50

55

62

Regulation

Collateral Management

7

37

12

Identifying Liquidity Risk for Financial Stabilityby Sol Steinberg

CCP Recovery and Resolutionby Michael Wellenbeck

CCP Notionals Scoresheetby Amir Khwaja

Start Making Sense of The Databy Jenny Nilsson

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21

36

24

47

26

63

30

Trading

Post Trade

Clearing

6224

The Absence of Cash is the Silent Assassin!by Andrew Whiteley

Navigating the waters of EMIR, MiFIR and SFTRby Alan McIntyre

How do financial regulations impact clearing and margining in energy and commodities? by Aviv Handler

ROCKET EDITION 9 | SPRING 2017 www.theotcspace.com

The Magazine From OTC Space | News, Articles and Opinion on the Capital Markets

The Missing Link for LDI Strategies ● Buy-Side CapitalImpacts ● All-to-All Trading ● Order Management Systems ●

ISDA Docs For Bilateral Margin

A seagull keeping an eye on diners at lunch. The photograph

taken by the Editor

ABOUT THE COVER

ContributorsRocket • Edition 9 | Spring 2017 • theotcspace.com | 4

Peter Farley Senior Marketing Strategist, Capital Markets, Misys Peter focuses on the market dynamics and industry challenges that drive IT investment priorities in the Capital Markets. He has an extensive background as a financial journalist, market analyst and industry commentator. He now delivers that insight to complement Misys product and marketing communication activities.

Phil Langton Head of Collateral Management, NetOTCPhil brings over 30 years of experience across a range of financial products, having worked in trustee services, retail, private and investment banking as well as consulting more recently with some of the of the utility providers. He has held a number of senior roles across the industry in risk and funding, including Chief Risk Officer for Net OTC, head of Treasury Solutions for RBS; Global OTC Portfolio Manager for ABN, European head of collateral at UBS and head of Risk Management for Citibank Private Banking.

Aviv HandlerManaging Director, ETR AdvisoryAviv is a specialist in the regulation of the commodities, energy and financial markets and the managing director of ETR Advisory. He focuses on all streams of regulation including EMIR, REMIT, MiFiD II, CRD IV and MAR as well as applicable rules across the globe.

Amir Khwaja CEO, ClarusFT.comAmir has more than twenty years experience in OTC Derivatives and Technology. His prior positions include Director of Risk Management and Financial Engineering at Calypso Technology (2005-2012), CTO at SunGard Trading and Risk (2002-2005), CEO & Founder at Kronos Software (1998-2002).

John Lund Independent Consultant at Broadgate PartnersJohn has worked in capital markets for more than 15 years (10 at Accenture and over 5 as an independent consultant). He has extensive experience in derivatives and collateral management having worked both with the sell-side (clearing members) and buy-side (asset managers) and currently focuses on regulatory driven business change. He has previously worked with HSBC, Barclays, Morgan Stanley and Accenture.

Alan McIntyre Senior BA and Industry Relations Lead (Europe), Risk FocusPrior to joining the Validate.Trade team at Risk Focus, Alan was a Senior Business Analyst on DTCC’s Global Trade Repository programme and led the development and implementation of many of the EMIR reporting deliverables including Collateral & Valuation reporting, the ESMA Level 1 & Level 2 validations and the Inter/Intra TR Reconciliation. Prior to DTCC Alan has a wealth of experience across banking and asset management including roles at Barclays Capital, Omgeo, State Street Bank and BlackRock.

Simon DaviesSenior Consultant, The Field EffectSimon joined The Field Effect after nearly 20 years working in Investment Banking, with experience in securities finance and collateral management, prime brokerage and depositary banking, including process change, outsourcing, client and relationship management, and business development roles.

ContributorsRocket • Edition 9 | Spring 2017 • theotcspace.com | 5

Nick StaffordHead of Operations, The Field EffectNick’s experience includes Target Operating Models, Business Architecture, Functional Modelling. Currently on assignment with TFE regarding clearing, collateral and global regulation.

Jenny Nilsson Head of Product Marketing, triResolve, TriOptimaJenny is the Head of Product Marketing for TriOptima’s counterparty exposure management service, triResolve. She plays an active role in encouraging market take up of triResolve’s Portfolio Reconciliation, Collateral Management and Reporting Validation services. Jenny has over 8 years of derivatives market experience, starting her career at ICE where she subsequently managed client services teams, Jenny then joined TriOptima as a Business Manager in 2012. In her role in business management, Jenny successfully delivered a range of functional projects and is utilising this experience and product knowledge to drive the triResolve business forward. Jenny holds a degree in Business and Economics.

James Parascandola Credit & OTC Derivaitves/Dodd-Frank/Clearing & Execution, NewOak/MF Global Holdings LLCJames has more than 10 years credit derivative trading experience in buy & sell side roles and is presently an advisor to OTC derivative market participants assisting firms in navigating the most complex and highly regulated environment in financial markets history. Prior to joining State Street, James headed credit derivative trading and lead his firm’s effort to become a CDS clearing member at a leading FCM and global broker-dealer. In addition to serving as the firm’s lead OTC derivative representative, James spoke before the CFTC in Washington, D.C. on matters pertaining to OTC derivative regulatory reform. In 2003/04, James was one of four individuals who helped create and launch what is now the most widely traded credit derivative index family globally; the CDX family of credit derivative indices, while he headed investment grade index trading at Barclay’s Capital.

Sol SteinbergFounding Principal, OTC PartnersSol is a seasoned f inancial executive with subject matter expertise in OTC derivatives, Market structure, Trade Lifecycle, and Risk Management, among others. He has a wide-ranging network of asset managers, analytic providers, execution venues, regulatory, and government contacts.

Andrew Whiteley Director, Kona ConsultingAndrew has worked within financial services for more than 30 years, during which time he’s worked for Barclays, Lloyds & RBS at senior levels covering Payments, Intraday liquidity, Cash management, Treasury and Operational Risk.

Michael WellenbeckManaging Director & Founding Partner, Wellenbecks Advisory Services GmbHMichael has more than 20 years experience in the Exchange industry both as an executive responsible for defining and implementing strategy and also as a programme director responsible for managing change across organisations. In more than fourteen years at Deutsche Börse and more than six years at (NYSE) Euronext he was involved in designing and managing multiple clearing initiatives across Europe and the US.

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Rocket • Edition 9 | Spring 2017 • theotcspace.com | 7

Regulatory Horizon: Hope and Change Version 2.0Whilst the Obama Administration’s rally cry of ‘Hope and Change’ resonated with voters 8 years ago,

it signaled the beginning of the end of the status quo throughout the banking and financial service industries; and not coincidentally, annualized U.S. GDP growth above 3%.

Namesake regulations were borne, and regulations to regulate those regulations ensued. The business of compliance boomed and the business of trading swooned. Net losses of millions of jobs around the globe drove stakes through the hearts of trading desks,

operational support staff and numerous ancillary businesses and industries traditional to legacy sell-side market making business models. Borne were technology disputers, data management and mining initiatives, cloud infrastructures and armies of com-

by JAMES PARASCANDOLA

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pliance and legal professionals; albeit, only fractionally offsetting the economic impact of lost higher wages across the front-office and related support functions.

Dodd-Frank, Volker, EMIR, Basel and numerous other pieces of regulation forced firms to overhaul, reduce or exit once highly prof-itable businesses. The opportunity cost mindset of the Obama Ad-ministration was to ensure, at all costs, an event like the 2008 Finan-cial Crisis was not repeated. Toward the end of Mr. Obama’s term however, global regulatory bodies, perhaps acknowledging the

Regulation

Regulation Rocket • Edition 9 | Spring 2017 • theotcspace.com | 8

Act may provide a blueprint for what’s to drive regulatory infra-structure moving forward.

H.R.5983 – Financial CHOICE Act of 2016Introduced on September 9, 2016, Jeb Hensarling’s Financial CHOICE Act consists of a number of measures, intended to stimu-late growth while rescinding authority and reach of federal agencies and regulation.

The CHOICE Act of 2016 amends the Dodd-Frank Wall Street Reform and Consumer Protection Act, among other Acts, to:

l repeal the “Volcker Rule” (which restricts banks from making certain speculative investments);

l amend Title II of Dodd-Frank;l with respect to winding down failing banks, eliminate the

Federal Deposit Insurance Corporation’s orderly liquidation authority and establish new provisions regarding financial institution bankruptcy; and

l repeal Title VIII of Dodd-Frank; the bill removes the Financial Stability Oversight Council’s authority to designate non-bank financial institutions and financial market utilities as “systemically important” (also known as “too big to fail”). Under current law, entities so designated are subject to additional regulatory restrictions. Designations made previously are retroactively repealed.

pending seismic shift looming over the financial service industry, be-gan to recognize and admit reform went too far to the detriment of markets, participation and prospects for robust economic growth.

Under the Trump Administration the United States will LeadWhile the Basel Committee finally came to its senses at the end of 2016 with regard to relaxing punitive capital regulations, the incoming administration in the United States has not been shy about letting the world know reforming 2008 Financial Crisis borne regulations will be top on its agenda. And while there re-mains much uncertainty about what the regulatory landscape will look like 12-18 months from now, I’ll present what I feel are highly likely outcomes and corresponding market, participant and for-eign government and regulatory authority responses.

The First Order of BusinessWith an across-the-board control switch from Democrats to Re-publicans in Washington complete, a simplistic less is more ap-proach will be undertaken by the new administration. Mr. Trump has called for an initial two prong approach to addressing regula-tion consisting of a moratorium on any new, non-essential rules and a by-federal agency review and identification of all restric-tive to growth/nonessential regulations. Additionally, House Fi-nancial Services Committee Chairman Jeb Hensarling’s CHOICE

Mr. Trump has called for an initial two prong approach to addressing regulation consisting of a moratorium on any new, non-essential rules and a by-federal agency review and identification of all restrictive to

growth/nonessential regulations


l provides for Community Bank and Credit Union Regulatory Relief as Dodd-Frank disproportionately burdens smaller financial institutions and credit unions via its one-size-fits-all methodology;

Certain banks may exempt themselves from specified regulatory standards if they maintain a certain ratio of capital to total assets and meet other specified requirements; the Qualifying Capital Election

The bill also amends the Consumer Financial Protection Act of 2010 to:

l restructure the Consumer Financial Protection Bureau by replacing its director with a bipartisan commission;

l subject the commission to the congressional appropriations process, expanded judicial review, and additional congressional oversight; and

l limit the commission’s authority to take action against entities for “abusive” practices.

In addition, the bill:

l modifies provisions related to the Securities and Exchange Commission’s managerial structure and enforcement authority;

l eliminates the Office of Financial Research within the Department of the Treasury;

l revises provisions related to capital formation, insurance regulation, civil penalties for securities laws violations, and community financial institutions;

l scales back the Federal Reserve’s regulatory and supervisory authority, subjecting it to increased congressional oversight and accountability while utilizing a rules based approach to the deployment of monetary policy; and

l holds financial regulators accountable to explain, justify the costs of and receive Congressional approval (regulations having an economic impact of $100mm or more) for any new regulation

Clearly less is more and accountability is king. And while I disa-gree in that certain covenants of CHOICE, such as setting a “10% leverage ratio and CAMELS rating of 1 or 2” bar in or-der to achieve numerous aspects of regulatory relief (i.e. the Qualifying Capital Election), from Section 165 of Dodd-Frank or Basel III capital and liquidity standards for instance, don’t go far enough at the onset, debate, comment and the legislative process would likely water down this conservative bar to some-thing more palatable (the negative impact to hiring and lending as a result of the capital raising that would need to take place in order to meet the 10% leverage ratio by the 10 largest banks in the world would eliminate any economic benefit of being subject to less regulation), it’s a welcomed starting point. As is finally holding authors of regulations and regulatory agencies accountable.

Certain banks may exempt themselves from specified regulatory standards if they maintain a certain ratio of capital to total assets and meet

other specified requirements


OTC Derivative Market ImpactWith the end of Volker, comes the end on erring on the side of cau-tion for the dealer. Regulatory fines sky rocketed under the Oba-ma Administration as did the cost of capital. Sadly, it has become more profitable for banks to not extend liquidity and trade than the converse. This has resulted in a remarkable drain of liquidity, par-ticularly across OTC derivative markets. True, new entrants have picked up some slack, but the aim of regulation intended to reduce bank’s market profiles in OTC derivatives while increasing the base of non-bank participants simply hasn’t panned out – and it’s been to the detriment of the participant whom regulatory reform was in-tended to benefit. Therefore a repeal of Volker will provide a much welcomed boost to liquidity in FX, Equity, Rate and Credit derivative markets – at a time when its likely going to be needed most. In lock-step with reigning in the Federal Reserve’s ability to deploy market manipulating rhetoric and policy, a rising rate environment as a func-tion of stimulative fiscal policy, the CHOICE Act’s repeal of Volker will be overlaid onto resumptions of normalized credit cycle ebbs and flows – a major stimulant to OTC derivative market growth.

What’s good for some may not be the case for others however. While it’s true that JPMorgan and Citi have stated no plans exist for a resumption of proprietary activity, the forces of competition within the market may throw caution to the wind and almost force legacy firms to increase proprietary trading as a function of in-creased market making. If those firms opt to not loosen the spig-

ot, legacy OTC derivative competitors Morgan Stanley, Barclay’s or Bank of America will be lurking in the wait, just ahead of eager disruptors in Citadel, DRW or SIG. So this reform is likely to usher in, and force ‘re-participation’ by firms who had been regu-lated out, or to the sideline of providing liquidity to clients. Clear-ing is likely here to stay but alternative clearing solutions such as CMEs recently proposed ‘hybrid sponsored access model’ may struggle to gain traction as the cost of capital descends. What is almost assured is that more clearing clients will be onboarded, prime brokerage franchises will resume growing and consolida-tion amongst etrading platforms will accelerate.

Regional ResponsesNot quite akin to the cheapest-to-deliver, the Euro Zone would be forced to amend mirroring aspects of EMIR, MiFID and PRIIPS regulation; or it will find itself at a significant competitive disad-vantage to the United States. To that end, Brexit may prove to be a boon for the United Kingdom; a region which should be able to more quickly and nimbly align itself with a more competitive financial service industry infrastructure across the pond once sepa-rated from the Euro Zone. Simply, I’d expect a domino effect to take place around the globe lead by the U.S., the U.K. and the Euro Zone; as regional regulation takes cues from the most advanced economies and the extraterritoriality footprint from Dodd-Frank, and later EMIR shrinks.

While it’s true that JPMorgan and Citi have stated no plans exist for a resumption of proprietary activity, the forces of competition within the market may throw

caution to the wind and almost force legacy firms to increase proprietary trading as a function of increased market making

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Identifying Liquidity Risk for Financial StabilityThe global financial crisis highlighted the importance of liquidity in functioning financial markets. Pre-2008, market participants received easy access to readily available funding and were ill-prepared for events that transpired during the credit crisis. Failure to adequately assess and manage liquidity underpinned major market turmoil, triggering unprecedented liquidity events and the ultimate demise of Bear Stearns, Lehman Brothers and other financial institutions previously thought too big to fail.

by SOL STEINBERG

T he global financial crisis has promoted a renewed fo-cus on managing liquidity risk. Lack of liquidity, in the midst of all the panic, left many firms unable to raise sufficient funding, forcing them to liquidate their posi-tions at huge losses, further fueling the fear of a sys-

temic crisis. In an attempt to avert a meltdown of the banking sys-tem and deep global economic recession, central banks had little choice but to inject liquidity into the financial markets. Almost 10 years on, awareness of liquidity risk has become the norm and its management essential to the viability of financial institutions.

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Trading Rocket • Edition 9 | Spring 2017 • theotcspace.com | 13

Looking ahead, effective risk management strategies must address the major issues that compromised firms during the drawdown. Liquidity should not be viewed as a short-term operational issue, but as a central component of long-term business strategies.

Types of LiquidityLiquidity risk is the risk that a company or bank may be unable to meet short-term financial demands. This usually occurs due to

Figure 1: Liquidity spiralsLoss spiral and the margin / haircut spiral

Reduced positions

Higher margins

Initial Losses

Prices move away from fundamentals

Losses on existing positions

Funding problemsfor speculators

the inability to convert a security or hard asset to cash without a loss of capital and/or income in the process. There are two dis-tinct types of liquidity: Market and Funding. Market Liquidity incorporates key elements of volume, time and transaction costs (bid/offer spread). These dimensions equate to the amount of assets that can be sold at any time within market hours, with minimum losses and at a competitive price. Market liquidity can be difficult to measure depending on the asset type, whether the asset is fungible, and the time horizon to liquidate the asset.

Funding Liquidity is the ability to settle obligations on short notice. To do this cash can be raised by the sale of assets or new borrowing. Accurate and timely forward cash flow projec-tions are crucial to effective liquidity management to maintain adequate funding.

Traders provide market liquidity. Their ability to do so depends on funding availability. Funding for traders is affected by market li-quidity. Under stressed conditions, both market and funding liquid-ity reinforce each other, leading to liquidity spirals. See Figure 1.

The Collateral and Liquidity ChallengeInstitutional Liquidity One of the core functions of banks is to take deposits and turn them into loans and securities. In order for this to go well, banks have to maintain enough cash on hand to meet their usual rate of individual withdrawals when depositors want access to their cash. If banks fail at this, they may have to sell assets quickly to raise cash. That can depress the market for what is being sold, if participants perceive a crisis in certain asset classes.

Central banks have often stepped in to provide short-term li-quidity to banks under duress, resulting in a shift on how banks treat certain types of lending, therefore, leading central banks to consider providing liquidity to nonbank financial firms.


Private lenders and credit providers have stepped into certain parts of the market where banks have stepped back as a result of new regulation. This has helped maintain liquidity, but it also means that central banks may have to expand their lending poli-cies accordingly. This prospect raises an important question:

How should institutional liquidity, in nonbank financial firms, be regulated? Even though traditional banks provided the bulk of market liquidity leading up to the crisis, large-scale withdrawals from prime money market mutual funds also played an important role. Since then, the Securities and Exchange Commission (SEC) has taken measures intended to reduce the risk of money fund il-liquidity.

There is also growing concern about the risk that other types of open-ended mutual and managed funds could face under li-quidity pressure in a future crisis. Mutual funds cannot fail per se as losses are passed to shareholders. The concern is instead that large and rapid investor redemptions across a significant number of funds could trigger sales of assets with low market liquidity, in turn, driving momentous price declines and transmitting financial stress to other institutions.

In response to these concerns, a new SEC proposal requires open-ended mutual funds (other than money market mutual funds) to establish liquidity management programs and increase disclosure on the liquidity of their asset holdings and practices related to meeting investor redemptions.

Market LiquidityMarket supervisors have recently increased the minimum amount of cash on hand that banks must hold in order to keep overall risk to the market at a minimum. The way a bank determines how much capital must be kept back is through the use of the Sup-plemental Leverage Ratio, outlined in the Basel banking rules.

Certain derivatives and repo rules further add to the amount of liquidity banks must have at any time.

The goal of these changes was to guard against underestima-tions of risk over time. One of the critiques to emerge out of the great financial crisis was that both banks and regulators viewed most banking activities as innately low-risk activities and, thus, al-lowed risk-based requirements to remain too low.

However, changes in regulation always come with consequenc-es. Banks were used to keeping a certain amount of cash on hand and, somewhat, suddenly had to significantly increase their li-quidity. To do that, they abruptly pulled back from parts of the fixed-income market, among other things. When the banks acted together, as a result of new rules, overall market liquidity was di-minished. Or was it? Market participants must determine if it is an empirical reality that liquidity has declined and where. Are there private players that can step in? Can markets adapt? We must be clear on the reality of markets today.

Central Bank LiquidityCentral banks have taken on an increasing role in guiding financial markets through monetary policy. Radical policy shifts, like nega-tive interest rates, have created new realities for market participants raising questions about the role of high-quality collateral and its availability. Demand for high-quality collateral is likely to continue to increase as more derivatives activity happens on exchanges, re-quiring counterparties to post low-risk collateral in order to miti-gate credit risk. Central bankers will be under pressure to ensure the availability of high-quality collateral to keep markets moving.

Transaction Cost Analysis (TCA)For investors that are interested in bonds, they need to take into account transaction cost analysis. Essentially, this means


evaluating a potential bond investment on certain intrinsic char-acteristics such as how long the bond will take to mature. If an investor plans to trade a bond before it reaches maturity, measur-ing liquidity can be tricky. Using volumes alone may not take into account adverse circumstances like forced selling.

A comprehensive TCA will look at factors like price sensitiv-ity, transaction volume and any excess return. Taking all of these measurements together can give you a better profile of a given bond or basket of securities regardless of how often they trade.

Portfolio ConstructionLiquidity risk can be diff icult to hedge against because unlike other forms of risk, it cannot be diversif ied away. But, it’s not all bad news. Historically, illiquidity happens in the market on an episodic basis. So, if investors hold a security to maturity, they won’t pay the liquidity cost as they might if they move in and out of a security before maturity. Asset managers can also help by creating portfolios that handle illiquidity in cer-tain asset classes such as private debt, whereby creating a spe-cif ic portfolio sleeve that will capture the premiums for hold-ing these assets to maturity, while adding diversif ication to the overall portfolio.

Swing Pricing Swing pricing is another mechanism asset managers can use to provide a smooth return to investors. When an asset manager uses swing pricing they will move the Net Asset Value (NAV) of a port-folio up or down depending on the direction of net asset flows. In practice, this may mean that investors enter a product at a slightly higher price, but to redeem the cost to exit will be lower. Inves-tors will have to be savvy about why they redeem from a fund with swing pricing, because the use of the mechanism can create

a slightly higher tracking error, even if the risk profile of a given fund hasn’t changed.

Regulatory Impact

Sell-Side RegulationSell-side institutions are obliged to comply with multiple regulatory requirements across the various jurisdictions in which they

Level 1

Total net cash outflows: total cash inflows minus cash outflows in a stressed scenario for 30 days

Level 2

Level 2A Level 2B

No haircut: Stocks of liquid assests includes cash,

sovereign bonds and central bank

reserves Subject to 15% haircut:

Includes certain government, covered or corporate bonds

Subject to 20-50% haircut: Includes lower-rated corporate RMBS

and some equities. Comprising no more

than 15% of total HQLAs.

Comprising no more than 40% of total HQLA

HQLA

Figure 2: Key characteristics of a HQLA asset


operate. Supervisory authorities, including the Basel Committee, the Committee of European Banking Supervisors and the Federal Reserve Bank have issued guidelines in an effort to establish sound, system wide liquidity management practices.

Basel III introduced two key ratios – Liquidity Coverage Ratio (LCR) and Net Stable Funding Ratio (NSFR) – to provide guid-ance to banks to ensure short-term and long-term financing re-mains resilient, which the Fed have also gone on to adopt.

The LCR metric aims to ensure that “a financial institution maintains an adequate level of unencumbered, high quality assets (see Figure 2) which are sufficient to cover outflows in a defined sur-vival period, 30 days, under acute short-term stress scenarios” de-fined by the regulators:

High Quality Liquid Assets

Total Net Liquidity Outflows over 30 daysLCR = > 100%

The NSFR ratio seeks to calculate the proportion of long-term assets which are funded by long-term, stable funding.

Available amount of stable funding

Required amount of stable fundingNSFR = > 100%

l Stable funding includes: customer deposits, long-term wholesale funding (from the interbank lending market), and equity.

l Stable funding excludes short-term wholesale funding (also from the interbank lending market).

By introducing new ratios, the Regulators seek to achieve the following goals (see Figure 3):

l Promote short-term resilience of bank’s liquidity risk profilel Improve the banking sector’s ability to prepare for financial

and economic stressl Provide a sustainable maturity structure for assets and

liabilitiesl Incentivise banks to fund their activities with more stable

sources of funding

Buy-Side RegulationFund managers are under increasing pressure to ensure strong li-quidity risk management practices are being carried out. Regula-tors such as the SEC, FCA and ESMA have outlined guidelines on liquidity risk management practices that funds should apply.

Additionally, the Securities and Exchange Commission (SEC) proposed a set of liquidity risk management requirements for reg-istered open-end mutual funds and ETFs. The proposal is part of a broader SEC agenda to modernise the Investment Company Act of 1940 (’40 Act) and to address perceived systemic risk concerns relating to the asset management industry. The program includes four key components:

l Maintain a classification of portfolio securities into six liquidity time buckets, based upon how quickly the securities can be converted in to cash.

l Calculate and maintain a capital requirement under the “three-day liquid asset minimum”.


l Have the fund’s board directly approve, oversee, and periodically review their fund’s liquidity risk management practices.

l Provide enhanced disclosure in both new and existing reporting (such as Form N-1A, N-PORT and N-CEN).

Under ESMA, the AIFM Directive requires that authorised AIFMs must (except in relation to unleveraged closed-ended AIF):

1. Adopt appropriate liquidity management procedures for the AIFs that they manage;

2. Ensure that the liquidity profile of each AIF’s investments is

aligned with the AIF’s obligations, for example, in relation to redemptions;

3. Ensure that an AIF’s investment strategy, redemption policy and liquidity profile are consistent with each other; and

4. Monitor each AIF’s liquidity risk, including in light of regular stress tests against both normal and exceptional liquidity condition

Mitigating Liquidity RiskLiquidity risk can never be fully mitigated. It has to be managed along with market, credit and other risk factors. Given its tendency to com-pound other risks, it is almost impossible to isolate liquidity risk.

Figure 3: Net Stable Funding Ratio Components and Liquidity Coverage Ratio Components

Net Stable Funding Ratio Components Liquidity Coverage Ratio Components

Available Stable Funding Required Stable Funding Dec-15$

Mill

ions

LCR

%

Jan-16 Feb-16 Mar-16

250

200

150

100

50

0

250

200

150

100

50

0

HQLA Net Cash Outflow LCR 160%

140%

120%

80%

60%

40%

20%

0%


The best line of defense is a strong liquidity policy and manage-ment framework where liquidity risk is robustly measured, moni-tored and managed. Liquidity management should be viewed as an integral part of a firms’ long-term enterprise strategies. This should include a plan to manage risk both in normal operating environments as well as under the occurrence of extreme liquidity risk circumstances. To ensure best practices are met a firm must look to target the following areas:

l The right tools to provide detailed liquidity classification for internal and regulatory reporting.

l A flexible technology framework for firms to implement their own strategies, i.e. scenario analysis and stress-testing.

l Subject matter experts that can advise on what best practices should be undertaken for their business model.

l Asset Optimisation: the ability to track the movement of assets, especially in a large institution, to ensure assets are used in the most cost effective way.

l Comprehensive data infrastructure to manage and maintain data to ensure a high degree of accuracy.

l Exploring Liquidity in the marketplace.l Liquidity management requires identifying the optimal

balance between liquidity risk and profitability.

A study from Deloitte (see Figure 4) shows the difficulties in managing Liquidity Risk can be for a sell-side client:

What Tools Can Help?Treasury:Treasury has a very important role to play within the banks. They are responsible for ensuring the banks financial obligations and reg-ulatory requirements are met. Treasury requires accurate projec-

tion of multi-currency cash positions out to several weeks or even months. The more transparent and readily available information is for them the more effective managing liquidity risk will be, as they are better placed to minimise external borrowings by funding short-falls in one place with any available surpluses in other.

Risk officers: Liquidity risk has become a key fundamental part of the risk of-ficer’s role and responsibility. By building a set of stress scenarios, a risk officer can run tests based on idiosyncratic, systemic and combined stress to determine the impact this may have on the firm’s balance sheet. However, risk officers often face challenges when it comes to having adequate data available to estimate li-quidity. Many firms have opted to set rules to group particular assets into categories in order to help aid segregation and tracking.

Tools:Liquidity needs to be managed on an ongoing basis. This demands a new approach to liquidity risk management, as firms need to adopt a more holistic view to meet their regulatory compliance and busi-ness objectives. To do this effectively, firms are increasingly relying on technology providers that can provide a single integrated solu-tion, incorporating reporting, scenario modeling to support stress testing, data management and analytics. With advanced analytics, such as stress testing, scenario analysis and survival horizons, firms can capture and measure exposures that may impact their liquid-ity position. Monitoring liquidity risk positions has increased the emphasis on automation and timeliness of data integration. Auto-mated and customisable reporting, that allows segmentation and tagging of positions based on the liquidity in your corresponding markets, is also necessary. This information can be utilised to quan-tify and report liquidity risk at different levels of aggregation.


Figure 4: How challenging is each of the following for your organisation in managing liquidity risk?

Investment operational and other capabilities to comply with Basel III NSFR (Net Stable Funding

Ratio)

Developing a credible set of systematic and idiosyncratic liquidity stress scenarios

Obtaining sufficient, timely and accurate data

Investment in operational and other capabilities to comply with Basel II LCR (Liquidity Coverage Ratio)

The quantification of the liquidity stress scenarios

Controlling the consumption of liquidity on a daily basis across the whole firm

Cash flow forecasting

Establishing and then monitoring liquidity risk appetite

Establishing a contingency funding plan

Managing any other key balance sheet ratios, e.g. customer loans / customer deposits

40%

32%

31%

31%

27%

23%

22%

18%

16%

15%Note: Figures represent the percentage of respondents

identifying each item as extremely or very chanllenging.

Source: Deloitte University Press | DUPress.com


Enterprise Risk Management FrameworkThere is no one set model to manage liquidity. However, firms that adopt an enterprise risk management framework that addresses the market, credit and liquidity will be able to manage risk based with an integrated view of all the risks impacting their portfolio. As a leading provider of risk, analytics and trading solutions, Quantifi has strong liquidity risk management capabilities.

Cash Flow Management

l Project future cash flow across a defined period of time. As a result, being able to make decisions based on the forecasted balances.

l Monitoring intra-day liquidity positions against expected activities and available resources.

l Capture the average daily volumes of trades per asset class to monitor the time to liquidate at the position or portfolio level.

l Build a set of stress scenarios, based on idiosyncratic, systemic and combined stress to simulate the cost of liquidity and funding.

l Include IM and VM calls on cash flow balances to provide a further level of accuracy.

Treasury/Risk Controls

l Categorise assets in various classes depending on asset type. For example, users will be able to classify HQLA asset classification sets under Basel III making the LCR ratio calculation a seamless process.

l Create several stratifications based on asset types - such as country of risk, rating, currency, maturity and date of issue.

l The ability to match maturity concepts for both assets and liabilities.

ConclusionLiquidity represents the ability to rapidly trade large amounts of securities with minimal impact on market prices. Regulation is placing new limits on market making activities within banks and forcing asset managers to account for liquidity risk when con-structing client portfolios.

As the credit crisis demonstrated, ignorance of liquidity risk is dangerous. Sourcing and transferring risk in the secondary mar-ket has, consequently, become difficult. This should be a con-cern to all market participants. Credible analysis of transaction liquidity and associated cost is difficult, but not impossible. New technologies offer a deeper understanding of liquidity drivers in the market and, in turn, can help improve market activity. As-set managers can and should prepare for future liquidity events, but preparation alone will not prevent extreme volatility of asset prices. Fixing the structural imbalance and fortification of mar-ket infrastructure is what is truly required.

References:Brunnermeier, M. K., and L. H. Pedersen. 2009. Market Liquidity and Funding

Liquidity. Review of Financial Studies 22:2201–2238. Available online - http://rfs.oxfordjournals.org/content/22/6/2201.abstract.

Bank for International Settlements (BIS). 2013. Basel III: The Liquidity Coverage Ratio and Liquidity Risk Monitoring Tools. Available online - http://www.bis.org/publ/bcbs238.pdf.

Linklaters. (2015). AIFM Directive. Available online - http://www.linklaters.com/Insights/20100218/Pages/09_OperatingConditions.aspx.

Securities and Exchange Commission. 2015. Investment Company Reporting Modernization. Available online - https://www.sec.gov/rules/proposed/2015/33-9776.pdf.


by JENNY NILSSON

In 2009, a new international consensus was formed when the G-20 met in Pittsburgh. International leaders agreed that transparency and oversight of the OTC derivatives market was key to international financial stability.

Start Making Sense of the Data

Post TradeFo

tolia

.com

One of the goals was that OTC derivative contracts should be reported to trade repositories. The global regulatory community took decisive action to make that goal a reality.

With the introduction of data repositories and the specification of data required to be reported, regulators thought they would be able to understand aggregate exposure and risk in the swaps market. However, despite the significant resources spent by the industry on establishing and reporting to swap data repos-itories it is clear that just getting the data reported is necessary but not sufficient to achieve transparency and oversight. Problems persist. The data in trade repositories often cannot be identified or matched against counterparties. Incomplete information is re-ported, and the integrity of the data is compromised.

With reporting accuracy now in the regulatory crosshairs and financial and human resources limited, the pressure is mounting for a cost effective, efficient solution for market participants to vali-date and align their data.

Increasing regulatory scrutinyIn its advisory letter of November 17, 2015, the US CFTC re-minded swap dealers and major swap participants “of their obligations with respect to the data reporting requirements.” In the face of persistent reporting issues and failures, the CFTC empha-sized that, “Accurate and timely information and data is essential to maintain a transparent and well supervised swap marketplace.” Similarly in February, 2015, ESMA indicated that its “supervisory focus has now shifted to the quality of the reporting data.”

While the reporting regimes in the US (single-sided reporting) and Europe (double-sided reporting) do differ, the regulators in both jurisdictions mandate that whether the market participant self-reports or delegates its reporting, it remains responsible

Post Trade Rocket • Edition 9 | Spring 2017 • theotcspace.com | 22

for complying with the reporting requirements and ensuring its timeliness and accuracy.

The recent drumbeat of commentary from regulators in the US and Europe emphasizes that now is the time to address the exten-sive inaccuracies in data reporting to ensure data integrity.

Errors persistThere are still a lot of issues in the data that is being reported and these fall into several categories including:

l mistakes in core economic datal inconsistent reporting of identifiersl duplicative reporting of swapsl data reporting delays and omissions

Clearly identifying these errors and then fixing them is the way to clean up reporting data. The key is doing this efficiently and intelligently. Getting a holistic view of all data that has been reported in your firm’s name is proving a challenge in itself. When you try to align that data with that of your counterpar-ty, it becomes increasingly more complex. Adding to that, the challenge of data being reported in different repositories and jurisdictions, and the task becomes enormous. The industry must come together and find a solution. The question is, how can this be achieved?

Leveraging existing effortsRegulators and market participants alike have long identified the benefits of bilateral proactive reconciliation. Proactive reconcilia-tion has been key to minimizing the number of collateral disputes that market participants report under existing risk mitigation rules. The process is even mandated under global risk mitiga-

tion requirements (EMIR, Dodd Frank, etc.). Bilateral portfolio reconciliation have been one of the real success stories of the bi-lateral OTC derivatives market and leveraging this process will not only assist firms in improving the accuracy of regulatory re-ported data but will also benefit regulators when trying to make sense of the data in the trade repositories.

Proactive reconciliation of reported data enables trend analysis. If you reconcile your reported data daily and have the tools to log and investigate the differences you observe, over time you start seeing patterns in those differences. Once you understand where you regularly have problems, you can identify the cause of the is-sues and fix them upstream.

Key to this process is having a comprehensive break manage-ment workflow that is able to track the differences and assign root causes. As firms fix problems on a proactive basis, trade book-ings and corresponding data will gradually align over time. Align-ing your own internal data with your reported trade is a first step towards improving the data. Equally as important is reconciling your reported record with your counterparty’s reported record. Benchmarking yourself with the rest of the industry should not be overlooked and is an integral part of ensuring data accuracy. Im-proving the data quality will benefit the whole market and make the reporting regimes worthwhile.

For more information

Reduce risk and enhance the performance of your OTC derivatives portfolio with TriOptima’s award winning post trade services.

www.trioptima.com

http://www.trioptima.com/services/triResolve.html


Many encountered serious issues managing the liquidity and collat-eral to meet their settlement obliga-tions. Experienced liquidity profes-sionals were already acutely aware

of the complexity and risk of daily management of provisioning intraday liquidity – cash. And in 2008, their concerns were proved when institutions that could no longer meet their obligations failed due to the absence of cash, in the right place at the right time. The Silent Assassin had struck!

by ANDREW WHITELEY

The Absence of Cash is the Silent Assassin!

In the crisis of 2008, known issues of timing and risk within settlement processes caused extreme stress across the industry and led to the failure of major institutions.

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Although 2008 highlighted the criticality of intra-day liquid-ity, regulators and the industry have been slow to reduce the likelihood of a sequel. Initiatives across payments, settlement and liquidity have required increasingly granular and frequent reporting but without significant change to cash settlement processes within and between institutions. Enhancements have typically been undertaken at asset class rather than at an institu-tion level. Since liquidity risks are so clear, and regularly tested, we should look to move away from just measuring to reduce liquidity risk. We have 20th century settlement model with 21st century risk.

Liquidity risk still exists and transaction volumes and values continue to increase, with current gross settlement values across markets of over 5 Trillion dollars a day. And that increased mar-ket demand is concentrated on existing settlement banks. This article suggests cross market efficiencies exist that can mitigate liquidity costs and risks whilst supporting growth in market ca-pacity.

Change activity continues to focus on transactional rather than the underlying payment and settlement activity. Netting is a logical answer to the capacity and cost challenge, however in many markets – especially complex derivatives – transaction

level netting is expensive and largely done where feasible. If in-stitutions can book payments at a gross level and settle netted exposures with major counterparties, considerable savings can be achieved, reducing liquidity requirements, cost and risk, al-lowing increases in transactional capacity.

This challenge resonates across all asset classes, and it’s across asset classes where most benefit can be derived by insti-tutions. The efficiency of cash settlement systems and liquidity risk management are not sexy topics; this is the domain of the back office! However, the scale of benefits in terms of cost and capacity justifies attention from Treasury, Risk and Payments organisations. So what to do? Firstly, identify the real cost of settlement in your business, including funding costs. Are there risk capacity constraints that limit profitable business growth? Understand the impact of halving costs or doubling capacity, and remember those same benefits exist across asset classes when assessing institutional benefits.

Regulators have seen the risk of the Silent Assassin – they have shone torches into corners of the back office – and spotted him! It is now up to institutions to decide how they respond and generate capacity and savings enabling business to grow profit-ability within the enhanced regulatory risk framework.

Initiatives across payments, settlement and liquidity have required increasingly granular and frequent reporting but without significant change to cash settlement processes within and

between institutions. Enhancements have typically been undertaken at asset class rather than at an institution level. Since liquidity risks are so clear, and regularly tested, we

should look to move away from just measuring to reduce liquidity risk. We have 20th century settlement model with 21st century risk.


by ALAN McINTYRE

Navigating the waters of EMIR, MiFIR and SFTRJanuary shed some light on the European regulatory reporting timelines

but provided a mixture of both relief and pressure.

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The industry breathed a sigh of relief when it became apparent that SFTR transaction reporting will most like-ly commence in Q4 instead of Q1 of 2018. The relaxa-tion was short-lived though, as the European Commis-sion then fired the starting pistol on the EMIR Article

9 RTS rewrite with a compliance date of November 1st 2017. The elephant in the room for both of these reporting regimes is the Jan-uary 3rd 2018 MiFID II date and their potential proximity to it.

Smooth-sailing or choppy seasThe SFTR relief came courtesy of ISLA (the International Se-curities Lenders Association) who published an opinion on the timelines associated with the implementation of article 4 of SFTR with an estimated compliance target date of Q4 2018, based on the remaining steps within the EU legislative procedures. The trade association for securities lending industry participants cautioned that these estimates are based on “a smooth-sailing scenario” and could move, based on issues in the adoption process. Bearing in mind that the EMIR RTS rewrite date has edged so precariously close to the MiFID II date because of delays within the adoption process for that RTS, it would seem prudent to consider the pos-sibility of choppier seas ahead.

The original Q1 2018 timeline for SFTR has to me seemed in doubt ever since the one-year delay was granted for MiFIR/MiFID II. The extra year to deliver MiFID II was granted so that firms would have more time to update their systems. To do so and then compound it by having something as large as SFTR transaction reporting coming only a few months later would therefore seem highly counter-productive. Though if the EMIR RTS rewrite had followed the original anticipated timelines through the corridors of Paris and Brussels, we would have been looking at a Q2 2017 compliance date, rather than only 2 months before MiFID II.

A date for the journalThe EU Commission publication of the revised EMIR RTS & ITS in the official journal of the European Union on January 21st has finally provided a compliance date for all the firms re-porting under EMIR to work towards. Wednesday the 1st of November at least avoids one much-feared suggestion (or con-spiracy theory) that suggested that the revised EMIR report-ing would go live in the same month or even the same day as MiFIR transaction reporting. A bullet has been clearly dodged here, but for banks, asset man-agement firms, and many oth-er firms with obligations to report under both regimes, the challenge of scheduling development, testing and im-plementation of reporting solutions and control frameworks for two very different projects that have a significant overlap will be very daunting.

Many of the banks with obligations to report under both EMIR and MiFIR will also have obligations to implement the HKMA Phase 2 reporting changes this summer. The Hong Kong Monetary Authority is introducing reporting of three new asset classes (Credit, Commodities & Equities) as well as additional sub-product types for the FX and Interest Rate asset classes al-ready reported. This is due to commence on June 16th and, given the HKMA’s well-known lack of tolerance for reporting errors, is a considerable undertaking in its own right. There is also the SEC’s Securities Based Swap Reporting (SBSR) which is the US Securities regulators outstanding section of Dodd-Frank reporting. After many delays, the exact timeline for SBSR is still unclear but is presumably sometime in 2017. Although as one wit suggested


to me at a recent event, perhaps the SEC is holding off to see if ‘the Donald’ repeals Dodd-Frank first!

For banks with a global footprint there are also derivatives re-porting requirements in Switzerland, Israel and South Korea to deliver this year. So, whilst the sheer breadth and scale of MiFID II will undoubtedly continue to hog the limelight, there is a con-siderable challenge to meet some or all of these reporting require-ments, whilst also initiating SFTR projects.

Scope and overlapLet’s consider the scope and similarities of these regimes to better understand the overlap and conflicts that might arise.

EMIR requires the reporting of all OTC and ETD derivatives

transactions and is focussed on systemic risk. The focus is on which entities have done which trades with each other as well as reporting the transaction or any material changes to each trade (the lifecycle events). Entities will be required to provide daily re-ports of the collateral and valuations of the trades.

MiFIR (MiFID RTS 22) requires the reporting of all transac-tions including OTC and ETD derivatives and cash equities, bonds, ETFs as well as pretty much anything traded on or trad-able on a European venue. The focus here is more on market abuse and the reports are therefore centred far more on who the parties and decision-makers involved in the transaction are. As the intent in RTS 22 is to report executions made for investment purposes the lifecycle-events are generally out of scope (unless they create a new trade), likewise the collateral information and the valuations aren’t required.

SFTR could be described as ‘EMIR for Security Finance Transactions’ as the focus is on systemic risk. ESMA is delib-erately following the model implemented under EMIR and is aiming to reuse as much of the existing framework as possible, including the Trade Repositories. Similarly, to EMIR, SFTR re-quires firms to report transactions, lifecycle events, collateral details and valuations.

When the time comes to implement SFTR, the work that the firms reporting will be doing on their EMIR solutions this year may well have impact on their future SFTR solutions (where the firms are seeking to utilise as much of their EMIR reporting sys-tems and governance as possible). For example, the EMIR RTS rewrite involves significant changes to the way that collateral is reported and since collateral will also need to be reported under SFTR, it therefore makes sense to consider the SFTR requirements as well, whilst determining what changes to implement now in the collateral management and accounting systems.

The challenge of scheduling development, testing and

implementation of reporting solutions and control

frameworks for two very different projects that have a significant overlap will be very daunting.


Identifiers and classificationsFor MiFIR and EMIR, the overlap is derivatives (OTC and ETD) as these are reportable under both regulations, but in very differ-ent formats and for different purposes. The EMIR RTS rewrite involves a considerable revision of the product identification and classification system. Firms will need to manage how they make changes to how they report the Asset Class and Contract Type fields without impacting related fields such as CFI code - which is reportable under both regulations.

Another interesting dynamic is the ISIN. Currently under EMIR, ISINs are only reported on Exchange Traded Derivatives, and the firms need to populate either an ISIN or an Alternative Instrument Indicator (Aii) (exchange code) based on whether the venue they traded on supports ISINs or Aii codes. On the other hand, OTC derivatives are reported using the so called ‘interim taxonomy’ which effectively describes the type of instrument rather than the actual instrument, for example, FX-FR for ‘Foreign Exchange For-ward’. Much has been written about ESMA’s controversial decision to endorse ISINs for OTC derivatives within MiFID II. Details are still emerging of how this will work in practice and the ANNA De-rivative Service Bureau (DSB) solution is slowly taking shape. The potential usage, or not, of ISINs for EMIR reporting could be an interesting one to watch. ESMA is due to publish a final version of the Validations document that relates to the new EMIR RTS and it will be interesting to see if there is anything further on this.

Aii codes is also an interesting and fairly painful one for firms. On

November 1st when the new EMIR RTS goes live, firms can popu-late either the ISIN or the Aii code that the exchange they traded on supports. However, two months and two days later when MiFID II goes live, European exchanges will all be required to use ISINs and the Aii code will no longer be acceptable under EMIR. I’m wonder-ing if any big ETD clients are pressuring the exchanges to bite the bullet and migrate to ISINs before November 1st to avoid any issues when they cut over to ISINs. One scenario would be that a firm re-ports a transaction in December with an Aii code and then needs to modify it in January and needs to determine whether to submit the original Aii code or the replacement ISIN.

Clarity and planningMore clarity should arise when ESMA publishes the final version of the Validations document for the new EMIR RTS, which I’m told should be soon. Likewise, when the final version of the SFTR RTS is published (in March, according to ISLA’s best guess). In the meantime, it is clear that 2017 is going to be a very demanding year for regulatory transaction reporting and the last three months in particular are looking very busy. My advice is to be mindful of how the designs and decisions put into place on one regulatory work-stream may impact those on other/future work-streams. It is crucial for firms to think about the overall control framework to best support all regulations once they’ve passed from the project phase into live. Finally, we are all worrying about the next chal-lenge. MiFID III anyone?

Much has been written about ESMA’s controversial decision to endorse ISINs for OTC derivatives within MiFID II. Details are still emerging of how this will work in

practice and the ANNA Derivative Service Bureau (DSB) solution is slowly taking shape.


by AVIV HANDLER

How do financial regulations impact clearing and margining in energy and

commodities?The European and global banking scene has been embroiled in a slew of changes

in the clearing and margining world over the last years, with the rules on variation margin for uncleared OTC deals coming imminently.

The entire investment firm community is caught by the uncleared margin requirements, while EMIR manda-tory clearing proceeds at its own pace. This has not only led to many operational challenges, but also increased the importance of margin and capital optimisation.

In the energy and commodities world, life is, as always, slightly different, with these rules having a lower impact, at least for now. This is for several reasons, of which two are key:

l Most entities are non-financial counterpartiesl Many of the products traded are not “financial instruments”

Non-Financial CounterpartiesFirstly, the majority of energy and commodity traders are, at this stage not investment firms, and considered under EMIR to be “Non-Financial Counterparties” (NFCs). As a non-investment firm, the majority of firms are exempt from MiFID. The appli-

cability of EMIR and the uncleared margin rules in the Europe-an jurisdiction depends on whether the entity is over the clearing threshold. Those above the threshold, a group known as “NFC+”, will be subject to much of the uncleared margin regime, and also mandatory clearing under EMIR, as Category 4 counterparties.

An entity is over the clearing threshold if the total outstanding gross notional value for trades which are not ‘risk reducing’ is over one of these asset class totals:

l Commodity derivatives- €3bnl Credit derivatives– €1bnl Equity derivatives – €1bnl FX derivatives – €3bnl Interest rate derivatives – €3bn

A 30 day average must be calculated by NFCs on a daily basis. In the event that one of the threshold values is exceeded, the


entity must notify the National Competent Authority and after a transitional period becomes an NFC+, where the more onerous rules apply. For commodities companies, the usual focus is, as ex-pected, the commodities threshold (see Figure 1).

There are several detailed rules around the calculation of the threshold in commodities, not least of which is the fact that the no-tional of a commodity in not a fixed value, but is instead defined as volume times price. There are many issues to consider in the calcu-

lation, for example which volume to use (is it the original volume or remaining volume?) and which price?

In terms of defining the trades in scope, those executed on a Regulated Market (RM), i.e. an exchange, generally do not con-tribute to the total, unless the RM in question is in a non-recog-nised third country. The calculation is performed for any trades in the global group in a non-investment firm entity. As a re-sult, those with significant positions on exchanges in non-

Figure 1: Measuring Derivatives Exposure

All trades OTC derivatives Speculative

NFC entities in group

Remove non “derivatives” and trade in recognised

Regulated Markets

Remove “risk reducing” 30 day average - daily calculation

Commodity derivatives €3bn

Credit derivatives €1bn

Equity derivatives €1bn

FX derivatives €3bn

Interest rate derivatives €3bn


recognised third countries have experienced issues with their to-tals. The rules around determining which trades are ‘risk reduc-ing’ and the appropriate record keeping around it also need to be respected.

What is a derivative?Of more significance is the definition of what constitutes a de-rivative, and is therefore included in the total calculation. A trade is defined as a derivative under EMIR if it meets one of the cri-teria in MiFID Annex I sections C4 to C10. Of particular inter-est are paragraphs C6 and C7, which deal with physical forwards, of which many are traded by commodity and energy companies. Under MiFID I, and therefore currently under EMIR, C6 states that the following are financial instruments:

Options, futures, swaps, and any other derivative contract relating to commodities that can be physically settled provided that they are traded on a regulated market and/or an MTF;

In effect, any physical forward traded on an exchange, or MTF (Multilateral Trading Facility) is a financial instrument, and there-fore contributes to the clearing threshold calculation. On 6 May 2015 ESMA issued new guidelines on how section C should be applied (ESMA/2015/675), which replaced the guidance in the original MiFID Implementing Act (EC 1287/2006). The relevant section primarily specifies the meaning of ‘physical’.

Section C7 deals with off venue trades:

Options, futures, swaps, forwards and any other derivative contracts relating to commodities, that can be physically settled not otherwise mentioned in C.6 and not being for commercial purposes, which have the characteristics of other derivative

financial instruments, having regard to whether, inter alia, they are cleared and settled through recognised clearing houses or are subject to regular margin calls;

The guidelines go into a great deal of detail on this definition, but in effect state that in order to be a financial instrument, the trade must be:

l Equivalent to an instrument on an RM or MTF, whether in the EU or third country

l Not “spot”l The pricing is standardised so that the price, lot, delivery

date or other terms are principally determined with reference to regular published prices, standard lots or delivery dates

l There are appropriate clearing or margining arrangements.

RealityWhen EMIR started to apply, very few commodity traders, and even fewer energy traders, became NFC-. While it is in reality hard for a product to comply with section C7, many trades are executed on exchanges or broker platforms. The run up to EMIR saw many broker platforms, which had until then been classified as MTF, change their status to “non MTF”. This was often brought about by introducing a discretionary element to its operation. An MTF was required to have non-discretionary operation, and this change offered an option for entities to execute physical forwards in such a way that they were not derivatives.

This, combined with the fact that trades executed on an RM are in any case not included in the total, resulted in the majority of companies in the sector being classified as NFC-. As a result, such companies are not subject to either mandatory clearing, or the uncleared margin rules.


Changed product definitions under MiFID IIMiFID II introduces several changes to Annex I Section C, and in particular C6 and C7. C6 under MiFID II reads as follows:

Options, futures, swaps, and any other derivative contract relating to commodities that can be physically settled provided that they are traded on a regulated market, a MTF, or an OTF, except for wholesale energy products traded on an OTF that must be physically settled;

There are two important changes here: firstly, the scope of caught physical forwards has been extended to cover trades ex-ecuted on an OTF, an Organised Trading Facility. It is likely that the majority of multilateral non MTF and non RM plat-forms will be classified as OTF, which will bring those products into scope.

The second change however, is equally important, namely the exclusion of “wholesale energy products” executed on an OTF which “must be physically settled”, which is distinct from the phrase “can be physically settled”, found in the main part of the paragraph. This exclusion is known as the “REMIT carve out”, due to the fact that any trade which falls under this clause would be caught by REMIT’s1 requirements. The guidelines for the MI-FID I version are replaced by text in Article 5 of the MIFID Del-egated Act of 25th April 2016, which defines the requirements for “must be physically” settled.

In all likelihood, many products in gas and power will benefit from the carve out, although this assumes that the current non MTF broker platforms will become OTF, and that the products are successfully specified as “must be physically settled”. Those trading non-gas and power forwards will have a larger impact. Section C7 has also been updated and under MiFID II reads:

Figure 2: The Ancillary Activity Test

Market size

Main business “Speculative” derivatives

All derivatives

Capital allocated to “speculative” trading

Total assets minus short term debtOR

<10% <10%>10% <50% <50%

Gas 3%Oil 3%Agricultural 4%Metals 4%Power 6%Coal 10%Other 15%Emissions 20%

Gas 1.5%Oil 1.5%Agricultural 2%Metals 2%Power 3%Coal 5%Other 7.5%Emissions 10%

Gas 0.6%Oil 0.6%Agricultural 0.8%Metals 0.8%Power 1.2%Coal 2%Other 3%Emissions 4%

Gas 3%Oil 3%Agricultural 4%Metals 4%Power 6%Coal 10%Other 15%Emissions 20%


Options, futures, swaps, forwards and any other derivative contracts relating to commodities, that can be physically settled not otherwise mentioned in point 6 of this Section and not being for commercial purposes, which have the characteristics of other derivative financial instruments;

The Delegated Act also further details how this section is to be ap-plied, in some cases defining and in others narrowing the definition. Note that there is no REMIT carve out in this section, which could well have the effect of pushing some currently off venue trades onto venues, which is in line with one of the original MiFID II objectives.

Coal and oil – transitional arrangementMiFID II Article 95 specifies transitional arrangements for “C6 energy derivatives” contracts, which refers to those in coal and oil. More precise definitions are found in the MIFID II Delegated Act Article 6. Such derivatives do not contribute to the EMIR clearing threshold, nor will they come under the clearing obligation, until 3 July 2020. Therefore a section of the market will remain NFC- until the transitional arrangement ends.

The EMIR review ESMA issued a report on 13th August 20152 as part of the EMIR entitled “Review on the use of OTC derivatives by non-financial counterparties”, which was the first of four reports issued. The re-port indicated that on the one hand, many small NFCs had been caught by EMIR, which had led to a heavy burden on compa-nies who make only occasional or ‘light’ use of derivatives. On the other hand, the report claimed that many ‘large’ NFCs cur-rently had the status of NFC-, despite the fact that some may con-sider them to be systemic. Amongst the recommendations was the proposed removal of the “hedge exemption” from the clearing

threshold calculation, with a corresponding increase in the level of the thresholds. This would take larger NFCs over the threshold, and make the calculation easier for the smaller ones. Other parts of the report suggest further compromises for “smaller NFCs”.

While there has not been much discussion on this proposal, it was mentioned again in the report into EMIR produced in late 2016 by the European Commission. It remains to be seen if the proposal will make its way into EMIR, which would likely lead to several energy and commodity traders becoming NFC+

Exemptions under MiFID II – The Ancillary Activity testCommodity and energy traders may use the “commodity dealer exemption 2(1)k” of MiFID I to remain outside of the rules, al-though some choose to set up regulated entities to undertake cer-tain investment services. MiFID II removes this blanket exemp-tion, which means that entities are required to obtain authorisation from the National Competent Authority, unless they are able to use one of the remaining exemptions. In most cases this will involve using the “Ancillary Activity” exemption found in Article 2(1)j, which requires those who primarily deal in commodity derivatives to show that speculative trading is ‘ancillary’ to the main business. The test is defined in Regulatory Technical Standard 20, which has undergone many changes and versions. RTS 20 was adopted by the European Commission on the 1st December.

The adopted version requires entities, or an individual entity, and in some respects a group basis, to pass two tests (see Figure 2):

1) “Market Size” – showing that trading activity in commodity derivatives is below one of eight thresholds, in each commodity. All activity must be below all of the thresholds.

2) “Main business” – that the main business of the entity is NOT speculative derivatives trading. This can be


shown in one of two ways:a. Derivatives ratio – that the ratio of speculative to total

derivatives trading is less than 10%. If above 10% the test can still be passed using lower thresholds.

b. Capital – that the capital allocated to speculative derivative trading is under 10%.

“Speculative” is defined as a “non-privileged” transaction. A priv-ileged transaction can be one of:1) Trades between two internal legal entities that serve liquidity

or risk management purposes.2) “Risk reducing” trades.3) Trades undertaken for mandated liquidity provision.

The details around the rules are complex and intricate and will be examined in a future edition of Rocket. However, it is import to note that the definition of “commodity derivative” uses the same basis as EMIR.

As a result of the exemption removal, some commodity and energy traders will likely become FC, bringing them into the mar-gining regime of EMIR and the uncleared margin rules.

Margining in physical energy, security in commoditiesWhilst non-financial trades are not governed by financial regula-tion, in fact margining is used extensively in many forms of en-ergy trading. In particular most forms of on-venue trading will be cleared, for example by intermediaries such as ECC or Nordpool clearing. Much bilateral trading is also governing by margining agreements, such as EFET3 Credit Support Annexes, which work in similar ways to ISDA CSAs.

Other forms of physical commodity trading are also ‘secured’ in different ways. For example, physical cargo trades, such as oil

tankers, are secured using letters of credit or other forms of trade finance. While these types of security are not strictly speaking a replacement for margining, the impact is still one of risk mitiga-tion. Thus, a status change of a trade from financial to physical does not necessarily mean that no merging will take place.

However, it is safe to say that due to the factors mentioned here, a large proposition of the market is not bound by many of the mandatory margining and clearing requirement being experi-enced by the financial sector.

What will happen? While the majority in the sector are not bound by the rules, we have seen that a great deal of activity is in fact already margined and cleared. We can expect merging and clearing to take greater significance in the sector due to several factors:

Firstly, some entities will become “FC” due to the exemption re-moval under MiFID II. Secondly, the results of the EMIR review, and the impact of the change in the definition of derivatives under MIFID II, could cause more entities to become “NFC+”.

Finally, the changes in the financial sector are likely to cause those who are investment firms to push margining and clearing onto NFC-s, leading to an overall increase in capital and margin being required to support trading. Due to the factors outlined here, the coming years are likely to see the importance of the rules that cur-rently impact most financial companies taking further hold in the energy and commodity world.

References:1 The Regulation of the wholesale Energy Market Integrity and Transparency EU

1227/20112 ESMA 2015/12513 European Federation of Electric Traders

Clearing Rocket • Edition 9 | Spring 2017 • theotcspace.com | 36

CCP Recovery and ResolutionOn November 28th, 2016, the European Commission (EC) has published a proposal for a framework for

the recovery and resolution of central counterparties and amending Regulations (EU) No 1095/2010, (EU) No 648/2012, and (EU) 2015/2365l1. This regulation is based on the work at the international level of the Financial Stability Board (“FSB”), the Basel Committee, Committee on Payments and infrastructures (CPMI) and International Organization of Securities Commissions (IOSCO). FSB

published in August 2016 a discussion note on “Essential Aspects of CCP Resolution Planning” and jointly with the Basel Committee, CPMI and IOSCO, a progress report on the work plan to enhance the

resilience, recovery planning and resolvability of CCPs2.

by MICHAEL WELLENBECK

Foto

lia.co

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Clearing


Thereby the proposed regulation misses out on the opportu-nity to implement a single CCP supervisor and Resolution Au-thority, which would be in a position to pool expertise and data and replace the current patchwork of CCP oversight. Today the regulation follows the national supervision approach as set out by EMIR, creating colleges around national regulators to super-vise CCPs. In an extreme stress scenario, where one or multi-ple CCPs are in danger of failing, a centralised approach would however provide maximum efficiency, as decisions have to be taken holistically considering multiple CCPs, Clearing Mem-bers, etc. at the same time. The CCP regulation chosen in 2012 under EMIR lead to a patchwork solution for CCP supervi-sion3, where Central Banks (e.g. De Nederlandsche Bank

l the competent authorities l the members of the ESCB l relevant national central banks l the competent authority of the parent undertakingl the competent ministry, where the Resolution Authority

referred to in point (a) is not the competent ministry;l ESMA;l the European Banking Authority (EBA).

The EC’s proposal uses the by now well accepted me-chanics known from the Bank Recovery and Resolution Directive (BRRD) as basis and adopts the recovery and resolution framework to the specific features of CCPs’ business models and risk profile, which is very much

different from banks.Unfortunately the regulation as proposed does not foresee any

level two regulation or Regulatory Technical Standards (“RTS”). Thereby the regulation will not be flexible to adapt to the future evolution of international consensus on CCP regulation, i.e. rec-ommendations by the Financial Stability Board (“FSB”) on recov-ery and resolution of CCPs, which are impending, or changes in EMIR.

The regulation proposes national Resolution Authorities, where each Member State shall designate one or more Resolution Author-ities that are empowered to use the resolution tools and exercise the resolution powers as set out in this Regulation. Resolution Authori-ties could be national central banks, competent ministries, public administrative authorities or other authorities entrusted with public administrative powers.

The Resolution Authority then will establish, manage and chair a Resolution College to carry out the resolution tasks and ensure cooperation and coordination with third-country Resolution Au-thorities. The Resolution College includes all relevant regulators for the CCP and its key Clearing members, comparable, but not limited to, the colleges overseeing CCPs under EMIR. Key con-stituents are:

l the Resolution Authority of the CCP;l the competent authority of the CCP;l the competent authorities and the Resolution Authorities of

the clearing members;

The regulation proposes national Resolution Authorities, where each Member State shall designate one or more Resolution Authorities that are empowered to use the resolution tools and exercise the resolution powers as set out in this Regulation.


(DNB), Banca d’Italia, Bank of England,…), National Banking Regulators (e.g. Bundesanstalt für Finanzdienstleistungsaufsi-cht (Bafin), Autorité de Contrôle Prudentiel et de Résolution (ACPR), Finansinspektionen, …) or Exchange Supervisors (Comisión Nacional del Mercado de Valores (CNMV), Co-missão do Mercado de Valores Mobiliários (CMVM), Komisja Nadzoru Finansowego (KNF), ..) were tasked with overseeing CCPs in different countries. The current patchwork character of CCP regulation has been reaffirmed by the EMSA Peer Re-view under EMIR 21 “Supervisory activities on CCPs’ Margin and Collateral requirements” published on December 22nd, 2016, where ESMA clearly states, that there is need to enhance supervisory convergence between national supervisors4. The report – in its limited scope – already identified a number of areas where supervisory approaches differ between national su-pervisors and includes recommendations to improve consist-ency in supervisory practices. Around each national regulator, colleges - with a high overlap of participants for the key CCPs - have been created that would need to work in parallel in the case of the potential failing of multiple CCPs. With the evolution of the last years, in 2017 where the listed and OTC Derivatives markets come more and more together in CCPs a new central-ised approach should have be considered.

Resolution Authorities, when taking resolution actions, can use a range of resolution tools individually or in any combination:

1. Position and loss allocation tools;2. Write-down and conversion tool;3. Sale of (CCP) business tool;4. (Transfer to) Bridge CCP tool;5. Any other resolution tool consistent with Articles 21

(Resolution objectives) and 23 (General principles regarding resolution).

Reading and commenting on the proposal should be of interest to clearing members of CCPs and their clients, since it might massively impact also none-defaulting clearing members and their clients. As part of its powers, the Resolution Authority can reduce the value of any gains payable by the CCP to non-defaulting clearing members (Variation Margin Gains Haircut-ting) and issue a resolution cash call, requiring non-defaulting clearing members to make an additional contribution in cash to the CCP up to an amount equivalent to their original contri-bution to the CCP’s default fund. The resolution cash call can come after and in addition to any calls for new contributions by the non-defaulting clearing participants already exercised under its rules by the CCP itself in order to replenish default funds used up due to a default of a counterparty. If a non-defaulting clearing member does not pay the required amount(s), the Res-olution Authority may require the CCP to place that clearing member in default and use the clearing member’s initial

The regulation will not be flexible to adapt to the future evolution of international consensus on CCP regulation, i.e. recommendations by the Financial

Stability Board (“FSB”) on recovery and resolution of CCPs, which are impending, or changes in EMIR.


margin and default fund contribution in accordance with EMIR to cover losses.

In addition, the Resolution Authority can use a loss and position allocation tool, i.e. it may terminate certain or all contracts (a) of the clearing member in default, (b) the contracts of the affected clearing service or asset class or (c) the contracts of the CCP in resolution. The focus of the position management tool is used to rematch the book of the CCP or bridge CCP. The loss allocation tool can be used for a number of purposes, including to cover the losses of the CCP, to restore the ability of the CCP to meet payment obligations and to re-capitalise the CCP and replenish its pre-funded financial resources to an extent sufficient to restore its ability to comply with the conditions for authorisation and to continue to carry out its critical functions.

It seems that the recovery and resolution tools will impact even client positions, which are held indirectly in client accounts and are segregated. Through EMIR the option to especially protect assets of indirect clearing participants has been created with the introduction of client asset segregation and portability. The pro-posed legislation might make it possible to override normal prop-erty rights and allocate loss to specific stakeholders as well as to withhold the payment of gains from the CCP, also impacting cli-ent and segregated client accounts.

Clearing members will have to adapt their clearing services agreements with clients, to reflect the required changes in the CCP rule books as part of the CCP’s preparation for the potential im-

plementation of recovery and resolution plans as well as the po-tential use of the powers by a Resolution Authority which might affect contracts entered into by the clearing member on a client’s behalf. In addition, clearing members will have to communicate the new, potential liabilities to their clients, i.e. the potential losses or costs arising from the exercise of recovery tools by the CCP or the Resolution Authority.

The proposal obviously is of interest to CCPs and their owners, as the CCPs in preparation have to:

l Prepare a detailed recovery plan and adjust their operating procedures and rule books to ensure compliance with the proposed regulation and to enable the application of the recovery and resolution tools.

l Address or remove any substantive impediments to resolvability (identified by the Resolution Authority and Resolution College)

The Resolution authority can also use write-down and conversion tools, that are similar to the “bail in” tool known from BRRD. The Resolution Authority can use the tool in respect of instruments of ownership and debt instruments or other unsecured liabilities (also issued by the parent of the CCP) in order to absorb losses, recapitalise the CCP itself or a Bridge CCP, or to support the use of the sale of the CCP at commercial terms.

It seems that the recovery and resolution tools will impact even client positions, which are held indirectly in client accounts and are segregated. Through EMIR the option to especially protect assets of indirect clearing participants

has been created with the introduction of client asset segregation and portability.


The Resolution Authority may take full control over the CCP, by

l Appointing a special manager to replace the board of a CCP under resolution. The special manager will have all the powers of the shareholders and the board of the CCP.

l Requiring the CCP under resolution, or any of its group entities or clearing members, to provide any services or facilities that are necessary to enable a purchaser or bridge CCP to operate effectively the business transferred to it.

Overall the Resolution Authority may directly or indirectly through the special manager exercise control over the CCP under resolu-tion to:

l Manage the activities and services of the CCP, exercising the powers of its shareholders and board and to consult the risk committee;

l Manage and dispose of the assets and property of the CCP under resolution.

Finally, the Resolution Authority might use its control to sell the CCP to a third party at commercial terms (sale of business tool) or transfer its business to a Bridge CCP (bridge CCP tool). The Bridge CCP must be a legal entity, which is controlled by the Resolution Authority and is wholly or partially owned by one or more public authorities, and it must have been created for the purposes of being a Bridge CCP. The transfer may take place without obtaining the consent of the shareholders of the CCP under resolution or any third party other than the bridge

CCP and without complying with any procedural requirements under company or securities law.

Last but not least it is also important for taxpayers to read and comment on the proposed regulation, as it currently includes the government financial stabilisation tools, an option for ex-traordinary public financial support under certain conditions.

This bears the risk that the proposed regulation creates a wrong incentive structure. The currently included option of extraordi-nary public financial support through the government financial stabilisation tools under certain conditions might create a moral hazard situation, by wrongly incentivising clearing participants to not contribute to recovery and resolution of a CCP in an early stage, and to wait and see if and in how far extraordinary public support is provided. There should be a concern that parties might try to avoid /delay the covering of financial losses within the CCP ecosystem either through the CCPs default waterfall early on, or through recovery and resolution plans, thereby willingly accepting or even provoking the spill over of losses to (other) none-default-ing Clearing members or even into the public sphere.

References:1 See: https://ec.europa.eu/transparency/regdoc/rep/1/2016/EN/COM-2016-

856-F1-EN-MAIN.PDF2 See: http://www.fsb.org/2016/08/fsb-publishes-discussion-note-on-essential-

aspects-of-ccp-resolution-planning-and-progress-report-on-ccp-workplan/3 For list of CCPs and regulators, please see: https://www.esma.europa.eu/sites/

default/files/library/ccps_authorised_under_emir.pdf4 For details please see: https://www.esma.europa.eu/press-news/esma-news/

esma-identifies-areas-improvement-in-eu-ccp-supervision


Figure 1: Recovery and Resolution ToolsNational Resolution Authority

Resolution College

CCP Holding

• Prepare detailed recovery [9] and resolution [13] plans • Obligation to ensure that recovery options can be applied [14]• Obligation to remove impediments to the resolvability of a CCP [16]• Special Management [50] to replace the board of a CCP • Power to suspend certain obligations [55] • Power to exercise control over the CCP [Article 58]• The sale of CCP business to third party tool [40]• Transfer CCP business to Bridge CCP tool [42]

• Position and loss allocation tools / Termination of contracts – partial or full [Article 29]

• Write-down and conversion tool: write down and convert instruments of ownership and debt instruments or other unsecured liabilities [32]

• Variation Margins Gains Haircut: Reduction of the value of any gains payable by the CCP to non-defaulting clearing members [30]

• Power to suspend certain obligations [55] of the CCP vis-a-vis GCM• Power to restrict the enforcement of security interests [56] • Power to temporarily suspend termination rights [57]

• Resolution cash call [31]: Additional Default Fund Contribution

• Government stabilisation tools [45]: financial support

CCP

Client

Tax Payers / Public

None Defaulting Clearing Member


Title Article Main Content without details

Resolution Authorities 3 The regulation proposes national Resolution Authorities, where each Member State shall designate one or more Resolution Authorities that are empowered to use the resolution tools and exercise the resolution powers as set out in this Regulation. Resolution authorities shall be national central banks, competent ministries, public administrative authorities or other authorities entrusted with public administrative powers.

Resolution Colleges 4 The Resolution Authority shall establish, manage and chair a Resolution College to carry out the resolution tasks and ensure cooperation and coordination with third-country Resolution Authorities. The Resolution College includes all relevant regulators for the CCP and its key Clearing members, comparable, but not limited to, the colleges overseeing CCPs under EMIR. Key constituents are: • the Resolution Authority of the CCP;• the competent authority of the CCP;• the competent authorities and the Resolution Authorities of the clearing members;• the competent authorities • the members of the ESCB • relevant national central banks • the competent authority of the parent undertaking• the competent ministry, where the Resolution Authority referred to in point (a) is not the competent ministry;• ESMA;• the European Banking Authority (EBA).

Recovery Planning 9 CCPs shall draw up and maintain a recovery plan providing for measures to be taken in order to restore their financial position following a significant deterioration of their financial situation or a risk of breaching their prudential requirements. CCPs or their parent undertakings where the CCP belongs to a Group, shall submit their recovery plans to the competent authority for approval 10, 11.

Resolution Planning 13 The Resolution Authority shall, after consultation with the competent authority and in coordination with the Resolution College, draw up a resolution plan for each CCP. The resolution plan shall take into consideration at least the CCP’s failure due to the default of one or more of its members, none-default events such as other reasons including losses from its investment activities or operational problems as well as the broader financial instability or system wide events. CCPs shall cooperate as necessary in the drawing up of resolution plans and provide the Resolution Authorities, either directly or through the competent authority, with all the information necessary to draw up and implement those plans 14.

High-level Overview of Key Provisions



Resolvability of a CCP 16 The Resolution Authority, in cooperation with the Resolution College shall assess the extent to which a CCP is resolvable without assuming any of the following: (a) extraordinary public financial support; (b) central bank emergency liquidity assistance; (c) central bank liquidity assistance provided under non-standard collateralisation, tenor and interest rate terms.A CCP shall be deemed resolvable where the Resolution Authority considers it feasible and credible to either liquidate it under normal insolvency proceedings or to resolve it using the resolution tools and exercising the resolution powers while ensuring the continuity of the CCP’s critical functions and avoiding to the maximum extent possible any significant adverse effect on the financial system. 16.Where the Resolution Authority and Resolution College conclude that there are substantive impediments to the resolvability of a CCP, the Resolution Authority, in cooperation with the competent authority, shall prepare and submit a report to the CCP and to the Resolution College. Within four months of the date of receipt of the report submitted, the CCP shall propose to the Resolution Authority possible measures to address or remove the substantive impediments identified in the report. 16.

Resolution Tools 27 Resolution authorities shall take resolution actions by using any of the following resolution tools individually or in any combination (a) the position and loss allocation tools; (b) the write-down and conversion tool; (c) the sale of business tool; (d) the bridge CCP tool; (e) any other resolution tool consistent with Articles 21 and 23.

Termination of contracts – partial or full

29 The Resolution Authority may terminate certain or all of the following contracts: (a) the contracts of the clearing member in default; (b) the contracts of the affected clearing service or asset class; (c) the contracts of the CCP in resolution.

Reduction of the value of any gains payable by the CCP to non-defaulting clearing members

30 The Resolution Authority may reduce the value of the CCP’s payment obligations to non-defaulting clearing members where those obligations arise from gains due in accordance with the CCP’s processes for paying variation margin or an economically identical payment

High-level Overview of Key Provisions (cont.)



Resolution cash call 31 The Resolution Authority may require non-defaulting clearing members to make a contribution in cash to the CCP up to an amount equivalent to their contribution to the CCP’s default fund.

Where the CCP operates multiple default funds, the amount of the contribution in cash referred to in the first subparagraph shall refer to the clearing member’s contribution to the default fund or default funds of the affected clearing service or asset class.

The Resolution Authority may exercise the resolution cash call regardless of whether all contractual obligations requiring cash contributions from non-defaulting clearing members have been exhausted.The Resolution Authority shall determine the amount of each non-defaulting clearing member’s cash contribution in proportion to the clearing member’s contribution to the default fund.

Requirement to write down and convert instruments of ownership and debt instruments or other unsecured liabilities

32 The Resolution Authority shall use the write-down and conversion tool in accordance with 33 in respect of instruments of ownership and debt instruments issued by the CCP in resolution or other unsecured liabilities in order to absorb losses, recapitalise that CCP or a bridge CCP, or to support the use of the sale of business tool.

The sale of business tool 40 The Resolution Authority may transfer the following to a purchaser that is not a bridge CCP: (a) instruments of ownership issued by a CCP under resolution; (b) any assets, rights, obligations or liabilities of a CCP under resolution.

The transfer shall take place without obtaining the consent of the shareholders of the CCP or any third party other than the purchaser and without complying with any procedural requirements under company or securities law.

Bridge CCP tool 42 The Resolution Authority may transfer to a bridge CCP the following: (a) the instruments of ownership issued by a CCP under resolution; (b) any assets, rights, obligations or liabilities of the CCP under resolution.

The transfer may take place without obtaining the consent of the shareholders of the CCP under resolution or any third party other than the bridge CCP and without complying with any procedural requirements under company or securities law.




Government financial stabilisation tools

45 The Resolution Authority may use the government stabilisation tools for the purpose of resolving a CCP where the following conditions are met:(a) the financial support is necessary to meet the resolution objectives;(b) the financial support is used as a last resort after having assessed and exploited the other resolution tools to the maximum extent practicable whilst maintaining financial stability, as determined by the competent ministry or the government after consulting the Resolution Authority;(c) the financial support complies with the Union State aid framework;(d) the competent authority requires the Resolution Authority to provide that financial support.

Special management 50 The Resolution Authority may appoint a special manager to replace the board of a CCP under resolution. The special manager shall be of sufficiently good repute and shall have adequate expertise in financial services, risk management and clearing services. The special manager shall have all the powers of the shareholders and the board of the CCP. The special manager may only exercise those powers under the control of the Resolution Authority. The Resolution Authority may limit the actions of the special manager or require prior consent for certain acts.

Power to require the provision of services and facilities

51 The Resolution Authority may require a CCP under resolution, or any of its group entities or clearing members, to provide any services or facilities that are necessary to enable a purchaser or bridge CCP to operate effectively the business transferred to it.

Power to suspend certain obligations

55 The Resolution Authority may suspend any payment or delivery obligations of both counterparties to any contract entered into by a CCP under resolution from the publication of the notice of suspension until the end of the working day which follows that publication.

Power to restrict the enforcement of security interests

56 The Resolution Authority may prevent secured creditors of a CCP under resolution from enforcing security interests in relation to any assets of that CCP under resolution from the publication of the notice of the restriction the end of the working day which follows that publication.

Power to temporarily suspend termination rights

57 The Resolution Authority may suspend the termination rights of any party to a contract with a CCP under resolution from the publication of the notice of the termination until the end of the working day which follows that publication, provided that the payment and delivery obligations and the provision of collateral continue to be performed.




Power to exercise control over the CCP

58 The Resolution Authority may exercise control over the CCP under resolution to: (a) manage the activities and services of the CCP, exercising the powers of its shareholders and board and to consult the risk committee; (b) manage and dispose of the assets and property of the CCP under resolution.

The control referred to in the first subparagraph may be exercised directly by the Resolution Authority or indirectly by a person or persons appointed by the Resolution Authority.



CCP Notionals Scoresheetby AMIR KHWAJA The jump of $150bn at ForexClear is believed to be from

the introduction of margining for FX products, a sudden enthusiam to clear them. Shanghai CCP are doing well with

OTC rate swaps having added $306bn of notional. Both JSCC and LCH actively use compression methods to eliminate notional hence the drops above.

January 2017CCP CRD FXD IRD

Exchange Traded DerivativesCME 17,709,984Eurex 637,243ICE Fut Europe 5,063,007LCH 76,814

Over The Counter DerivativesAsigna / Mexder 290,245ASX 691,320BME 1,743CME 66,186 15,093,975Comder 60,200Eurex 507,544HKEX 5,135ICE Clear Credit 916,305ICE Clear Europe

497,791

ICE Fut US 363JSCC 8,561 10,869,281KRX 290,254LCH CDSClear 42,451LCH ForexClear 372,658LCH SwapClear 129,321,262Nasdaq OMX 82,050SGX 41 170,623Shanghai Clearing

2,927,540

Grand Total 1,531,657 432,899 183,738,020Group Total 185,702,572

October 2016CCP CRD FXD IRD

Exchange Traded DerivativesCME 18,202,257Eurex 601,427ICE Fut Europe 5,781,971LCH 37,165

Over The Counter DerivativesAsigna / Mexder 217,928ASX 666,030BME 2,992CME 76,521 15,989,600Comder 59,489Eurex 442,603HKEX 3,799ICE Clear Credit 931,272ICE Clear Europe

552,311

ICE Fut US 250JSCC 10,994 12,195,571KRX 318,390LCH CDSClear 38,315LCH ForexClear 222,538LCH SwapClear 135,848,715Nasdaq OMX 60,695SGX 48 175,195Shanghai Clearing

2,621,195

Grand Total 1,609,664 282,075 193,166,029Group Total 195,057,767

Change (October - January)CCP CRD FXD IRD

Exchange Traded DerivativesCME -492,273Eurex 35,816ICE Fut Europe -718,964LCH 39,649

Over The Counter DerivativesAsigna / Mexder 72,317ASX 25,290BME -1,249CME -10,335 -895,625Comder 711Eurex 64,941HKEX 1,336ICE Clear Credit -14,967ICE Clear Europe

-54,520

ICE Fut US 113JSCC -2,433 -1,326,290KRX -28,136LCH CDSClear 4,136LCH ForexClear 150,120LCH SwapClear -6,527,453Nasdaq OMX 21,355SGX -7 -5,066Shanghai Clearing

306,345

Grand Total -78,007 150,824 -9,428,009Group Total -9,355,191

With special thanks to:

All units in millions of USD, so 1000 above means 1 billion of USD.


of uncleared OTC derivatives in excess of 3 trillion (Euros or Dol-lars) initially affected. But this threshold reduces to 8 billion in four more steps up to September 2020.

And although many small banks and investors will still be well below even this, the larger businesses that are included will im-pose the expectation (and pass on the margin cost of the risk miti-gation) to their counterparties.

According to HSBC, the new margin rules originate from a global policy framework and timetable from the Basel Commit-tee on Banking Supervision and the International Organization of Securities Commissions (BCBS-IOSCO). They are a key part of the reform agenda put in place by the G20 countries as a response to the 2008 financial crisis. They are intended to reduce systemic risk in the non-centrally cleared OTC derivatives markets by en-suring appropriate collateral is available to offset losses caused by the default of a counterparty.

The International Swaps and Derivatives Association (ISDA) es-timates there are total derivatives in circulation with a gross notional outstanding value of some $700 trillion. Of that amount some

Collateral Management

In order to ease that pain (they will still have to stump up the $13 billion) they will need to be able to accurately calculate the margin amounts to not only ensure optimal collateral al-location, but also to prove compliance with the new regula-

tions.Although March 1, 2017 is being billed as ‘big bang’ when new

rules from Basel’s BCBS regulators require more specific margin calculations and collateral obligations to be extended to uncleared OTC derivatives, a handful of the world’s biggest banks in the US and Japan started adopting this practise last September. The EU (and some other jurisdictions) sought more time to comply and, as a result, the next wave of inclusion will see probably another 20+ banks added to the list in March.

But the real test of these new rules will be as the regulations are phased in to virtually every financial institution (many of whom have no previous experience of collateral) over the next three years. So far the implementation of both new Initial Margin and Variation Margin calculations for collateral will only see those in-stitutions with an Aggregate Average Notional Amount (AANA)

Get Ready – A $13 billion Collateral Headache is Heading in Your Direction

Banks and other financial institutions that use derivatives as investments or to hedge risk need to get ready, otherwise they are heading for a $13 billion headache as new collateral and margin requirements continue

to be phased in later this year.

by PETER FARLEY

Collateral Management Rocket • Edition 9 | Spring 2017 • theotcspace.com | 49

$86 trillion are uncleared and will be subjected to the new rules.Analysis by Deloitte estimated this will require the posting of an

additional $13 billion a year in collateral that would not be asked from derivatives cleared through a central counterparty. It said the incremental costs of the reforms for uncleared derivatives will be ten times that of those cleared. On the basis that the average port-folio size of non-cleared Euro interest rate derivatives is €85 mil-lion, the additional average costs amount to around €14,500 per transaction, it concluded.

Given the implications of other regulations on capital require-ments and the wider costs of capital it will be essential to have these calculations completed accurately. But, while this requirement only applies to new contracts entered into after 1 March 2017, an exten-sive list of lifecycle events may bring legacy trades into scope. The list includes but is not limited to amendments and cancellations, partial termination, allocation and partial novation, etc.

The two-pronged approach means firms will have to provide an initial margin when establishing a derivatives transaction (cal-culated on the basis of a formula that weighs the risk involved, the nature of the transactions, the currencies and credit risk of coun-terparties among other factors). But they will also have to calculate an ongoing variation margin that requires adjustments to the IM based on marking to market the collateral, often close to real time. This could easily see the need for adjustments to the collateral al-ready posted on an intraday basis to account for any deterioration in the value of the IM.

Those affected will therefore not only be required to be able to filter inventory to see what assets are eligible for collateral, but also what is available, at what time, and what is the most cost effective. There will have to be complete confidence in being able to trust the source of that information. It will be critical that the analysis is not only delivered fast, but is reliable. Partial views could prove to be

not only expensive mistakes, but possibly contravene the new rules.Of course, these services will be offered by third parties (or

even the large bank counterparties themselves on an outsourced basis) as some are already doing. But it will be in every organisa-tion’s interests to have its own version of the truth, particularly when it comes to disputes resolution. This latter aspect will be essential to resolve quickly, both because of the costs involved, or the risks of default. They will need to be ready to calculate, exchange, settle and challenge VM. Many smaller counterpar-ties will not be used to this activity and are only now realizing they not only need to do this, but that there could be incremental benefits in doing so.

The key to success will be better data analysis that integrates Front Office activity with the OTC portfolio descriptions, includ-ing market data for mark to market activity and variation calcula-tions, right through to back office settlement processes. Fortunate-ly, the technology is available to provide this that can aggregate data from multiple and disparate repositories, delivering fresh cal-culations when required to the firm’s decision-makers.

Like all new regulations this brings new challenges and new overheads. But, by taking a strategic approach banks and other investors will be able to mitigate both the risk and the costs in-volved. The key will be to start planning now. This must ensure the optimum capabilities are in place that provides full and ac-curate visibility of collateral assets and deploys them in the most advantageous manner for the business.

The new rules mean that collateral management is no longer just a back office appendage, but a key function with close links to trading, risk, liquidity management and capital optimisation. This shift into the spotlight means it has to be taken seriously. Anything less could have severe consequences and make the $13 billion ad-ditional costs the least of their worries.


There are many external drivers converging to create a perfect storm of unprecedented change in the deriva-tives markets:

l UMR (Uncleared Margin Rules), with the buyside impacted from 1st March 2017 in “cliff edge” style with a big bang implementation and no phasing. Despite intense lobbying to the regulators, a postponement looks unlikely

l Acceleration of migration from OTC to clearing (shifting the focus on the cleared model from compliance to optimisation as magnitude increases)

l Initial impact of the next wave of regulation including UCITS, UK FCA Treat Customers Fairly (TCF), MiFID II, etc.

Unlike the sell-side, where regulatory impacts are largely uni-form and generalisations can be made this isn’t the case for the

Buyside Challenges: start of a seismic shift to a new era?The buyside have faced many challenges over the last few years, but 2017 is shaping up to be a vintage year. And just like several bottles of Châteauneuf-du-Pape, this year is likely to leave a very large hangover.

by JOHN LUND

‘buyside’, a term that covers participants as diverse as pension funds, asset managers, regional banks and building societies to name but a few. Even focusing on asset managers, the impact differs enormously between those using only uncollateralised FX derivatives and more sophisticated participants with existing collateral management infrastructure. The focus for the former might be on building infrastructure from scratch in a matter of weeks whereas for the latter it is very much around the legal doc-umentation challenge.

Impacts on the buysideThere are however several common themes emerging around the impacts on the buyside of this market change:

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l Significant increase in margin call volumes due to several factors (dual CSA approach, zero threshold, reduced MTA, split calls between cleared / uncleared)

l A material increase in cleared collateral requirements: by late 2017, large funds would have been clearing for 18 months, by which time cleared IM could be significant and thus justify active rather than passive management

l Combined with the above, an increase in uncleared margin requirements accentuated by tighter eligibility and switch to daily processing

l Market shift to intraday processing (e.g. UMR requirement to settle some margin calls same day)

l Complete re-work of the legal framework supporting buyside derivatives trading

Whilst these impacts are not necessarily new, 2017 represents a ‘step’ change with the potential for material impact on fund re-turns. As a result, the business case for strategic investment in in-frastructure upgrade will become more compelling.

Focus for investmentGiven the breadth of the impacts set to hit during 2017, where should buyside firms focus their efforts? Four areas are likely to

require investment by buyside participants to meet the challenges ahead:

l Operating model (especially operations and other support functions)

l Treasury Managementl Legal Frameworkl Front office decision making

Operating Model: a step change required for asset managers?An asset manager with around 50 funds under management might today only exchange collateral on 5-10 calls daily. If the dual CSA approach is adopted, this combined with reduced MTAs, no thresholds and introduction of margining for funds with FX only could result in the same asset manager having to exchange collateral on 25-50 calls daily, representing a fivefold increase.

Another consequence of UMR is the shift to same day process-ing of margin calls; whereas today calls received may be processed during the day well into the afternoon, the need to settle collateral same day imposes much earlier deadlines of 8-10am. Using the simple example above, the capacity to deal with both effects

An asset manager with around 50 funds under management might today only exchange collateral on 5-10 calls daily. If the dual CSA approach is adopted, this combined with

reduced MTAs, no thresholds and introduction of margining for funds with FX only could result in the same asset manager having to exchange collateral

on 25-50 calls daily, representing a fivefold increase.


would have to increase from 1 to 25+ margin calls per hour, with effort concentrated during the crucial 8-10am window.

Whilst the impact will differ by participant, this change should be the catalyst for many to review the suitability of their current operating model as the consequences of doing nothing could be significant with material impact:

l consistently meeting margin calls late under the new rules represents regulatory risk

l overnight financing charges may be imposed by the parties involved

l an inability to support same day settlement may rule out some counterparty banks which could result in higher swap prices

Hence 1st March is likely to represent a tipping point where the potential benefits far outweigh the costs of infrastructure upgrade.

Treasury Management: can the buyside cherry pick the best parts of the sell-side model?The sell-side has long invested in treasury management infrastruc-ture and more recently in centralised ‘collateral units’ to create a real-time view of cash and collateral availability with a ladder pro-jecting usage over several days, which allows optimal usage of in-ventory. Much of the buyside however operates cash management based on stale data from yesterday’s close to project current and future cash flows.

The switch to intra-day processing, with collateral settling same day, creates a big incentive for the buyside to adopt sell-side treas-ury techniques. Under the new regime, collateral moves will be agreed throughout the day right up until the cut-off times (which could be well into the afternoon for some assets). In the case of a

margin call for instance, the amount and type of inbound collater-al might not be known until late morning / early afternoon. The current passive approach would leave any ‘late’ cash received on custodian deposit at poor rates whereas an active approach would invest overnight at short notice yielding much better rates.

Various market drivers over the next year are likely to make the case for investment in active Treasury management much more compelling.

The legal quagmire: an inconvenient truthUMR has shone a spotlight on the buyside approach to creating, maintaining and using the legal documentation supporting OTC de-rivatives trading. The effort to get existing legal data fit for purpose has been huge and highlighted many risks and issue with the current creaking infrastructure which will only be magnified by UMR.

A good analogy might be discovering your house has rising damp – the signs have been there for years, but in the short term it has been easier to ignore these and paper over the cracks, and at some point the problems unexpectedly reach a tipping point forc-ing urgent remedial action.

And for many firms UMR has been the straw that broke the camel’s back, exposing fundamental deficiencies that can no long-er be ignored:

l OTC derivatives trading permitted without supporting legal docs resulting in material (unknown) counterparty risk (inconsistency between trading systems and legal docs)

l The collateral management platform not reflective of CSA actual terms, creating risk that ineligible collateral could be accepted and operational cost in exception management

l Insufficient control around archiving and storage of legal documents making quick retrieval difficult (which


is precisely what would be required in a stressed market situation)

Market factors are coming together to create a compelling case for action to completely rebuild the legal ‘ecosystem’:

l Creation of a single ‘golden source’ representing the master record of all legal terms and used by trading systems, collateral systems and any reporting or reference platforms

l Updated processes to ensure terms are accurately captured and maintained

As collateral optimisation comes to the fore, 100% accuracy of legal terms will be essential to avoid costly errors. Take for ex-ample a non standard CSA with restricted cash but broader non cash eligibility (in terms of currency). Under UMR non cash posting may attract an additional 8% haircut where there is a cur-rency mismatch; such rules require watertight terms capture and dissemination to the collateral systems. The current laissez-faire approach where collateral preferences are high level will no longer work in the new environment.

Front Office Decision Making: the paradox of choiceThe old bilateral model was very straightforward with a clear di-vision of labour: fund managers focused exclusively on fund in-vestment strategy, the execution desk for derivatives operated a ‘fire and forget’ model where any derivative trade was executed on the price alone and collateral management was in many ways an afterthought. Collateral terms were straightforward, static and broad and the magnitude and frequency of calls meant that little thought was required for the collateralisation process (if indeed it was required at all).

If the start of clearing in 2016 was the ‘canary in the coalmine’ for what is to come, UMR on 1st March is likely to represent the fi-nal warning for change before it’s too late. The confluence of these two changes in particular will start to make a material difference to fund returns during 2017. This unprecedented market change is likely to bring about changes which have been predicted for years but which have not (yet) quite left the drawing board:

l An incentive for fund managers to consider the true lifetime cost of derivative trading across multiple venues (cleared v non cleared, etc.)

l A move for fund accounting systems to more accurately attribute this true cost of derivative trading to the appropriate sub-fund both for optimal collateral usage but also to ensure compliance with TCF

l A driver for product managers to review the continued viability of certain products under the new regulatory regimes (e.g. share class hedging)

l A transition towards more targeted and sophisticated use of scarce collateral

l The recognition of the importance of accurate enterprise wide data repositories to maintain, store and update crucial data (e.g. legal terms, cost of collateral, fees, etc.)

Consider a fund with a large OTC derivatives book, which is likely split between cleared and uncleared. After 8 months of clearing, IM may now be into hundreds of millions and increasing, swap pricing is incentivising elective clearing and UMR will add further collateral cost from 1st March. Add on the direction of travel of collateral eligibility (towards cash), now may be the time for asset managers to introduce more sophisticated collateral management combined with integrated front to back flows to join the dots between


the front and back office. And in particular, a toolkit to assist deci-sion making of both the front office (around execution venue selec-tion) and the back office (around optimal collateral management).

Summary: how should the buyside forge a path through the swamp?This article has explored several themes around the challenges the buyside faces in 2017. Many of the ideas are not new and have been talked about for years (indeed Sep 2017 represents a decade since the G20 Pittsburgh summit). In some ways however, 2017 marks the end of the ‘phoney war’ for the buyside with two pil-lars of derivatives regulation (clearing and UMR) now firmly in place and maturing rapidly (Trump notwithstanding). These are

starting to make a real impact and moreover this can be quantified against real rather than theoretical data, which makes any business case for related strategic investment far more compelling. A logi-cal first step is to capture accurate metrics to support a business case (see Table 1).

These are some examples of the way market change is increas-ing the hidden cost to the buyside of transacting derivatives. For many, 2017 is likely to represent the point at which these costs start to exceed the investment in infrastructure required to counter these changes. Hence now is the time to look holistically at what strategic change is required to support the derivatives market of 2017 not that of 2006. And unlike previous years, hard data is rapidly becom-ing available to support this call for action.

Table 1: The Path Through the SwampThe Issue A Way forward

Financing costs through maintaining excess buffer at the CCP An incentive to invest in more sophisticated treasury management

Financing costs from single currency margining The driver to invest in in-house currency managementFinancing costs from supporting same day settlement A driver to upgrade operational platforms to support same day

settlementOperational cost incurred through dealing with exceptions arising from poor or inconsistent storage of legal terms data

An incentive to invest in a complete overhaul of your legal framework

Cost of collateral (opportunity cost) through sub-optimal allocation of collateral

The incentive to invest in some form of collateral optimisation

Review of clearing fee model and associated oversight An understanding of the opportunity to optimise clearing fees represents an incentive to invest in a proper oversight and reconciliation function


With the implementation date of 1st March looming ever closer, it would appear that banks and clients still have some way to go to be ready in time. SIFMA AMG recently wrote to regu-lators to advise that only 8% of the regulatory-

compliant CSAs needed had been executed by their members so far and hence they have asked for a six month transition period to be put in place. This would allow trading to continue with existing

The Collateral Cliff Edge – Variation Margin on the BrinkThe new Variation Margin regulations impact all financial entities as well as systemically important non-financial entities that deal in uncleared OTC trades. This means that from March onwards, all new trades will need to be captured under a collateral agreement and margined daily with collateral posted to cover the MTM movements. Whilst this may sound simple in principle to achieve, entering into a collateral agreement is no simple task.

by PHIL LANGTON

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broker / dealer relationships post 1st March rather than see cli-ents blocked from trading the OTC market. Given the volume of agreements still needed to be put in place, there is a genuine fear that liquidity could dry up completely in some markets.

On top of this, banks are not focused on resolving the issues that smaller firms must overcome to get ready. Most banks are offering a halfway house solution by providing infrastructure or valuation services (at a cost) but is anyone providing a one stop shop end to end solution?

Buy Side Barriers to Overcomel Volume of Agreement Negotiationsl Client Portfolio Analyticsl Risk Manager Approvals l Back-stop Collateral Buffersl Collateral Optimisationl New Policy/Governancel Infrastructure Implementationl Settlement Issuesl Cost Benefit Casel Resourcing

Banks themselves are not immune from the issues with the sheer volume of agreements and legal negotiations creating increasing pressures on their legal teams. Bringing in external consultants and contractors can only go so much in the remaining time frames and this is forcing banks into a situation of prioritising their client relationships. Even going as far as to suggest that they will have to stop trading with some clients as the date edges ever nearer.

It was estimated that circa 150,000+ of existing collateral agree-ments would need to be renegotiated by the time the dust settles on the new rules and that is before the impact of new clients is

taken into consideration. On top of this, there are a number of clients that are exempt from the rules that wish to volunteer to collateralise. This would allow them to improve pricing and gain access to longer tenors, but they find themselves crowded out in the prioritization process as well as needing to find the expertise to take on such a process.

On top of this, the regulations themselves are still not finalised in all jurisdictions, with differing approaches being applied on various aspects such as implementation dates, product coverage and how to manage trades with entities captured in non-netting jurisdictions. Asian countries such as Australia, Hong Kong and Singapore for example, propose an exemption for countries that cannot obtain enforceability opinions whereas the European rules have suggested a 2.5% portfolio cap. How this works in practice is left open for interpretation with local law claw back always a risk for banks and clients operating in these jurisdictions.

Buy Side denial or good gamesmanship?There is a part of the buy-side community that has taken the view that as they themselves are not regulated by the various bodies im-posing the new rules (can you explain?) that they are therefore not captured under the rules. Whilst this may be technically correct, they are impacted at the point they trade with a bank or entity that is regulated and hence this will dramatically cut down the list of eligible trading partners they have post March. It is true that they can trade away for a period, but this may require setting up new trading lines within their risk departments who I am sure will only have a limited appetite for credit to unsecured trading entities out of Asian countries.

There is also a significant cost impact to the buy-side if they continue to trade uncollateralised. Whereas historically you could always find a dealer that would be willing to under-


take a trade for relationship pricing purposes, it is now almost impossible to find a bank that will discount a price after tak-ing into consideration the cost of their own market risk hedge (banks can no longer warehouse risk), the funding cost for col-lateral they will need to post on their market risk hedge, the cost of capital for storing a long dated uncollateralised trade on their balance sheet to maturity as well as the P&L reserve they must take (CVA charge) for managing the counterparty risk to term.

When all of this is priced in, clients will see a 300-400 basis point increase in execution costs or a restriction on tenors and products that banks are willing to trade uncollateralised in order to optimise their balance sheets. It is also worth considering that the increase in executions costs needs to be weighed up against the increased support costs that a client moving to collateralising trades for the first time will incur.

Whilst the traders will benefit from access to a wider range of ex-otic products as well as longer tenors and better pricing and hence may be pushing their firms to go down the collateralising route, the risk management departments will be picking up new default and market risks to manage as well as having to find and fund eligible collateral in a form acceptable to the banks and all this can only happen after they have negotiated agreements and brought in ex-pertise and infrastructure through which to manage the process.

Some clients feel that these costs are already being built into their increased trade pricing so are looking for banks to supply solutions to all their issues or pick up / share some of the costs for the pleasure of their future business.

Build or Buy?As collateral management in the OTC market has historically been associated with bank to bank or bank to high risk/high volume trading relationships, the infrastructure has been built in-house

and geared towards solving the banks needs rather than tailored to external client requirements. It has also tended to require a cli-ent install and several months of consulting in order to set up the systems and get them ready for go live.

That is all changing with nimble cloud based technology (CloudMargin, Lombard Risk Agile, TriOptima's triResolve Mar-gin, etc.) delivering quick to market solutions, which opens the market to outsourcing opportunities.

Some banks are offering to pay for infrastructure and simplified connectivity as a means to enticing their clients into being regula-tory compliant for their own needs. Others are proposing an OTC client clear model as an add on to existing clearing relationships or as a means to expanding their client fees. These only solve a single dealer relationship problem for a client and if they have multi-ple trading relationships then they could find themselves facing off to various solutions and infrastructures and still having to pay towards each one (see Figure 1). On top of this they still need to set up the new policies, governance, controls, settlement accounts, intraday reporting as well as hiring in resources to take on these functions.

Managing multiple margin calls will require a consolidated (treasury) function to take control of sourcing and funding the collateral. This also opens firms up to collateral realignment fail-ures, asset transformation and eligibility issues for the first time, not to mention valuation disputes and additional portfolio recon-ciliation issues.

This will all require projects to be set up, experienced staff or consultancies to be hired, governance, policy and best practice pro-cesses to be implemented; all of which require significant time to establish as well as access to an investment budget. The easier op-tion for some clients is simply to decide to exit using OTC products at present or to look at alternatives such as listed and clearing.


Figure 1: Prepare for Battle - How to Organise Your Teams

Bank 1 Bank 2 Bank 3 Bank 4 Bank 5

System A System B System C System D System E

Team A Team B Team C Team D Team E

Call matching and validation

Funding & Financing

Optimisation

Dispute resolution

Your firm

OR

OTC Team

Repo / Stock Loan Team

FuturesTeam

Funding Financing Optimisation

Fund / Custodian Fund / Custodian Fund / Custodian Fund / Custodian Fund / Custodian Fund / Custodian




Others are expecting their main banks, brokers and dealers to help them solve the problem by providing infrastructure or valuation services, but most are still unaware that independent collateral utili-ties exist that could help them fast track collateralised trading and minimise the internal disruption.

So how do buy side firms navigate compliance with the new rules?

DocumentationFirstly, they need to sign a collateral agreement that defines the legal basis under which margin is called and the collateral is held. This can be done through the ISDA Amend/lSDA Protocol system in partnership with IHS Markit. The protocol works by getting us-ers to fill in a specific questionnaire in which they elect certain ele-ments they want and then the system matches them. When there is a match between the questionnaires, it is uploaded by both par-ties; but when the questionnaires do not match, the parties need to amend and resend them. Unfortunately, not everything can be cap-tured in the current questionnaires so you may end up in bilateral negotiations if you need to deviate from the standard i.e. the new CSA approach in the protocol doesn't allow for variation margin segregation, which a lot of 40 Act fund clients require.

Alternatively, AcadiaSoft is launching Agreement Manager which uses its own matching capabilities to create a single CSA record be-tween two counterparties. This means that if the initial question-naires don't match, users only need to amend the single record rather than resubmit an updated set of questionnaires. This allows you to agree the specifics of a new CSA and at the same time cre-ate a single data record that can serve as the source for any future changes to the document.

The lSDA Protocol and AcadiaSoft's Agreement Manager are

not the only CSA tools available to firms. Law firm Allen & Overy, along with Deloitte launched MarginMatrix. The tool codifies the laws in various jurisdictions and automates the drafting of legal documents, which can be used in variation margin compliance for repapering credit support arrangements.

The last resort is always to deal directly with Banks whilst lob-bying to get the attention of their legal team to allocate time to ne-gotiate bilaterally with you. This may mean you are put in a queue as banks are forced to prioritise the repapering of their existing collateralised clients to get them complaint by 1st March as well as dealing with the high volume of new client requests.

All trades or New Trades?One of the questions that clients will need to think about is whether to only start collateralising new trades going forward or whether to allow existing trades outstanding to be captured. There are pros and cons for each which depend on the products and volumes you have traded historically and or intend to trade going forward.

Positives are that you may be closing out an existing trade and hence may want old trades to be included for netting purposes in order to reduce margin requirements.

Banks will also get a capital benefit for moving a trade from un-collateralised to collateralised as the RWA allocation will move from an unsecured cost for remaining tenor to a secured cost for a ten/twenty day close out period. If a client has a number of long tenor trades outstanding, then the banks will be pushing for these to be captured under new CSA arrangements. If the savings are substantial then banks may be willing to offer incentives such as a supplying the collateral infrastructure, valuation services or run-ning monthly analytical services that allow for the calculation of collateral buffers.

The negatives are that the more trades you include under


an agreement, the greater the possibility for a reconciliation issue or valuation dispute. If the trades are typically all the same way i.e. do not net down, then this may potentially mean that you need to allocate larger collateral amounts to your collateral buffer to cover future margin call payments.

Rationalise Trading Relationships / Trading OptimisationTypically, clients have three to five main trading relationships that they deal with to cover their range of trading products. If each of the relationships offers to provide a different solution, then the client could end up facing off to five different systems and processes.

From a cost perspective, having lots of trading relationships going forward will be inefficient as clients will want to optimize where they execute OTC trades to minimise collateral postings as well as the amount of portfolio analysis needed to estimate future MTM/collateral requirements. By minimising trading relationships, it allows clients to put in place ‘risk trading tools’ that run portfolio optimization techniques such as ‘what if sce-narios’ to calculate which one will offer the cheapest execution costs, best eligible posting options (can be optimized for fund-ing costs) or which portfolio offers best netting opportunities. In addition, clients should look to amend trading patterns to maximize compression and risk netting by using specific reset and final settlement dates.

Valuations/ Analytical AnalysisWhereas previously some smaller firms may have been relying on banks to provide regular valuations on OTC trades monthly, they will now find themselves in a situation where they need to obtain daily valuations on both trades and collateral as well as needing to

run increased analytical models to ensure they can set aside collat-eral buffers to meet potential margin calls.

Risk/Treasury officers at buy-side firms will hold off from ap-proving collateral agreements until they have understood the risks and can control the impact that these bring and this is one of the main issues still facing the market as many firms do not have the capability to run these models daily.

Signing a collateral agreement can in some ways be seen as simi-lar to signing a blank cheque book as you suddenly find yourself in a daily ‘must deliver’ environment regardless of the amount of the margin call. Failure to deliver puts you in ‘default’ under the agreement and you risk having all trades closed out. For this rea-son, risk officers need to understand the potential mark-to-market value that the portfolio could explode out to, as well as needing a way to understand the impact that new trades will have on the portfolio. This means running some quantitative models such as monte carlo simulations in order to work out how much collateral could be required at short notice. Treasury will then need to cre-ate a backstop liquidity buffer that will allow them to source eligi-ble collateral to this amount within the required settlement time frame, which is normally same day or next day. The most com-mon techniques are to negotiate overdraft facilities that you can draw at short notice, use of repo facilities, use of transformation agents or to build up cash or collateral reserves.

The short-term solution to the valuation problem is to ask the banks to provide a feed of their own daily trade valuations directly in the collateral infrastructure being used. This means that a client’s ability to dispute valuations and margin calls is diminished until they can source valuations direct from their own trading or middle office systems. It also means that the funding cost of the collateral required is linked to the banks valuations until such time that a cli-ent can take control of this.


Some banks are offering out their risk systems for clients to use in order that the analytics aspect can be managed, whilst others prefer to look at more independent providers such as OpenGam-ma and Razor Risk to provide these reports.

The main question with any of these solutions is who will pro-vide the trade details and the market data that these systems need to calculate the reports as this increases the set-up time as well as the infrastructure complexity, not to mention who pays the data and service costs.

An alternative is to ask Banks to make their own credit simulation calculations available weekly/monthly to clients as well as putting in place a simplified new trade add on approach in between calcu-lation dates to estimate potential collateral requirements.

Asset TransformationSome banks are offering a multicurrency back-stop credit facility (collateralised through the posting of assets) which can speed up access to eligible assets that the treasury functions can draw down in the required currency to meet margin calls. This is similar to using a transformation agent such as Euroclear/Clearstream's Tri-party services, which switch existing holdings into eligible assets that can be delivered under the collateral agreement, only that it guarantees you will always be able to find a willing provider of eligible collateral.

Innovation in this area of the market is still in its infancy with peer to peer repo platforms just starting to take off as well as more established ecommerce providers such as BGC Partners entering the market with liquidity solutions such as their ColleX multi-asset platform which promotes collateral mobility and the ability to ad-dress the new reporting requirements.

Collateral OptimisationOnce collateral has been posted across a number of agreements then daily optimisation techniques can be applied to a Treasury inventory in order to work out the most optimal use of assets to meet daily collateral requirements. GFT Financial and Razor Risk have already developed tailored trade and collateral workbenches for clients and if these are linked into messaging or settlement platforms then the whole optimisation process can be reduced to a click of a button.

InnovationWith so many moving parts involved in managing a margin call, this is an area where continued innovation of infrastructure will help to streamline the process. The market has changed dramatically over the last three years with the introduction of initial margin being the main catalyst and the move to cloud based solutions another.

With the trend towards outsourcing taking pace there are still areas ripe for market innovation, such as the emergence of an OTC trade data warehouse/data centre to speed up connectivity to vendors and increase data quality, as well as increased use of comparison tools for transparency/regulatory reporting, and the need for new data standards for amending haircuts/eligibility and concentrations electronically but to name a few.

In the short term, with the date fast approaching, I would sug-gest that buy side clients reach out to their relationship managers to understand what solutions are being offered by their banks and bro-kers to help them get compliant and whether they will be allowed to continue dealing in OTC trades with them post 1st March - regard-less of whether they see themselves as exempt from the rules.

Alternatively look to partner with an outsource agent such as The Collateral Utility and let them take the pain away.


Margin Requirements for Uncleared Derivatives Update

The race to be ready for the bi-lateral margining of OTC derivatives is reaching its closing stage but there is still work to be done. As the February Initial Margin (IM) deadline has passed and the March

Variation Margin (VM) deadline looms, many firms are still not ready. There may be a method for some entities to continue trading without posting IM until August 2017.

by NICK STAFFORD & SIMON DAVIES

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However, for the vast majority of jurisdictions we have reached crunch time. Some firms are still lagging be-hind with operational work to exchange margin. For those with margin processes in place some key chal-lenges remain:

l The prioritisation trap for buy-side/corporate clientsl A reduction in the number of trading partnersl Collateral squeezel Challenges around the scale of renegotiating contractsl Operational impacts on both sell side and buy side firms

Operational efficiency, effective collateral management & automat-ed legal agreement management are key ingredients to mitigating current market changes, whilst providing a platform for continued success. We will explore, briefly, each of these key points below.

Regulatory updatemplementation dates are now set in stone for both Variation and Initial Margin: From 1st March 2017 all counterparties (regardless of size) will need to exchange VM for non-cleared OTC trades – with specif-ic requirements for two-way margining, minimum transfer amounts and removal of thresholds. (Note: At the point of going to press the CFTC announced that some trades would be exempt from VM from 1st March.) Initial Margin is a more complicated phased approach coupled with transitional arrangements in some jurisdictions.

IM phase in requirements are based on the gross month end notional value of non-cleared OTC. European dates are outlined in Table 1.

Institutions have not been active in getting ready for both IM and VM deadlines, and dealing with the complexity of multiple legal agreements covering VM and IM, whilst providing transitional ar-

rangements to capture existing Independent Amounts (IA) in cur-rent documentation before new IM requirements come in to force. Operational processes need to be in the final stages of implementa-tion to exchange margin – most see this as doing more with existing infrastructure, certainly whilst the impact becomes more evident, but this could put strains on operational efficiency. The biggest chal-lenge faced last year was the volume of re-papering required to in-tegrate margin rules into pre-existing legal agreements. Later in this article we will explore how this contributes to a prioritisation trap.

Jurisdictional Dislocation – a stay of execution?Singapore, Hong Kong and Australia are implementing IM rules differently to other jurisdictions. Instead of implementing phase 1 requirements with a single cut-off point (4th February 2017), they have opted for a transitional period up to 31st August 2017. Trades within these jurisdictions will be exempt from IM requirements in force elsewhere.

Some entities will be able to continue trading as normal until Au-gust 2017. Could this be an opportunity to take advantage of the delayed transitional arrangements? The practicalities (time-zones etc.) and balance sheet requirements of effected entities may still make trading in EMEA & North American regions more

Table 1: IM Compliance DatesDate Phase Value

4 February 2017 Phase 1 €3 trillion

1 September 2017 Phase 2 €2.25 trillion



1 September 2020 Phase 5 €8 billion


palatable; whilst it may make sense to move business to other enti-ties, there will still be an impact on the business operating model.

Collateral SqueezeRegulators intended to make OTC derivatives less attractive with bi-lateral margin regulation, & mandatory clearing. Some firms are moving away from OTC altogether, for those that remain sig-nificant challenges are ahead:

Collateral squeeze is a very real concern, the size of new de-mand on collateral is made worse by VM requirements being mostly covered with cash and/or government bonds. Equities and corporate bonds are mostly out of scope. Furthermore, the uni-verse of acceptable government bonds has been eroded as credit departments exclude countries such as Italy, Spain & Portugal. Whilst cash is the natural backstop, it isn’t desirable and will at-tract unappealing reinvestment rates especially when considering the extremely low (and sometimes negative) interest rate environ-ment we find ourselves in. This squeeze will naturally affect all collateralised products, as the supply of high quality and liquid collateral remains finite. The cost of trading collateralised prod-ucts will therefore increase making them a less attractive invest-ment and leading firms to seek alternatives.

Being able to manage the source of collateral, optimise what is available within the firm, and leverage custodial and triparty ar-rangements will become more important, as well dealing with the risk and operational processes required to deal with a more di-verse collateral book.

Repapering – The prioritisation trapThe re-papering prioritisation trap presents a number of prob-lems and opportunities for buy-side businesses and brokers. Low volume or value trading firms have and will find themselves lower

down the priority list for re-papering, posing the very real possibil-ity that they will not be able to trade quickly and efficiently with their preferred counterparty after deadlines pass. This may not be a general concern, but in an uncertain world and volatile trading environment it could lead to real business issues and a focus on corporate/buy-side treasury management.

Brokers will, naturally, focus on high volume/value counterparts to ensure agreements are in place. They may also incorrectly catego-rise buy-side counterparts into the wrong phasing tranche for initial margin. Buy-side firms should start pro-active dialogue with their counterparts to ensure they are aware of when phasing requirements apply to them and potentially seek out alternative trades or suppli-ers, and asses any costs and operational impacts that could arise.

Re-papering may present an opportunity for brokers who have an efficient agreement management process in hand. Buy-side firms will either take advantage of the opportunity to re-negotiate their existing agreements, to ‘shop around’ for a better deal, or consider seeking new counterparty relationships rather than face being unable to trade.

Documentation processesSome of the difficulties for brokers mentioned above are exacer-bated by manual negotiation & capture of legal agreements data. Through our extensive work on this subject over the past few years, we see three stages of maturity on the journey towards a more robust platform. Manual processes and tactical projects are no longer fit for purpose when considering the volume of re-papering we have seen recently and expect to continue (see Figure 1).

Tactical solutions, if effectively managed, can only provide you with a snapshot of data at that time. Once finished, the quality of data you possess will erode quickly. Increasingly, firms are look-ing to integrate vendor solutions or build in-house software to


Figure 1: Evolution of agreement management

APPROACH

SCOPE

PEOPLE

DATA

TECHNOLOGY

PROCESS

Ad hoc

Ad hoc

Lawyers

NarrowExcel Based

Excel

Manual

Tactical Projects

Narrow Scope

Paralegal / Grads

Narrow DatasetsSingle Purpose Data Model

e-DiscoveryOCR

Data Extraction

Remedian Factories Outsourcing

Strategic Platforms

Multi-agreement, Multi Entity

Higher Efficiency, Lower Cost

• Smart Docs Creation• Extraction Rules inc Auto

Generation• Data quality Rules Engine• Workflow Engine• Dashboard• Automated Outbound Data

Feeds• Document Lifecycle Mgt

Full Lifecycle ManagementService Utilities


provide a more strategic ‘BAU’ platform for documentation process-ing. This reduces manual expenditure and processing timeframes. There are opportunities to realise operational efficiencies and better automation at every stage of the agreement management process:l Origination: vendors and service providers are offering

electronic negotiation tools allowing counterparties to create and maintain legal agreements and, if integrated correctly, data can be passed automatically to downstream systems. This eliminates the possibility of manual ‘re-keying’ errors when capturing terms from physical documentation and delays in processing.

l Backload/BAU digitisation & extraction: there are a number of solutions in this space, allowing the digitisation of physical contracts and automatic extraction of terms with minimal remediation requirements.

l Governance: new platforms are emerging to provide governance rules against which golden source contract data can be interrogated, checked & remediated if required.

Reducing costs & optimising/extending collateralDemands for the correct type of collateral as well as amounts is ex-pected to increase the cost of trading OTC derivatives. This is cre-ating a greater push on the flexibility of collateral given and taken, whilst effectively managing risk and operational processes around it, inevitability leading to pressures on a firm’s operating model.

Along with increasing demands for better, up to date (if not re-al-time) contract information, and the downstream compliance of trading/collateral systems to this golden source, there needs to be input in to trading decisions – during the immediate execu-tion, when considering long-term viability of trades and the over-all book of business for pricing and risk management purposes.

All the above will involve a change to your business operating

model. When implementing new processes or technologies we recommend considering six key dimensions:l Peoplel Processesl Technologyl Products & Servicesl Geographyl ControlsConsidering the implications of these six dimensions in conjunc-tion with each other will help you to define a robust Target Operat-ing Model in preparation for change.

ConclusionsWe live in interesting times! It isn’t yet clear whether firms will be ready to meet the regulatory deadlines outlined above. Perhaps some entities can be prioritised, bearing in mind the jurisdictions with transitional arrangements. For those who do face early compliance, the pressures on collateral availability will have an impact on the cost of collateral not just for OTC trades but all collateralised products. Buy-side firms need to be aware of and prepare for the possibility of falling into the prioritisation trap, proactively seeking to re-negotiate agreements with existing brokers or seeking new relationships. We know that re-papering has been a significant challenge to the indus-try and some agreements will not be ready before deadlines. Capture and management of legal agreements data is becoming increasingly costly. With the pace of regulatory change unlikely to slow and clear signals that the UK will be leaving the single market, more work is likely to be required to legal agreements data. Implementing a ‘light touch’ and more automated platform for managing legal agreements data is an approach to mitigating the risk posed by short-term tacti-cal projects. Change is the status-quo, effective change preparation is the only way to ensure projects meet their strategic objectives.

http://www.misys.com/FusionCapital

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