BCBS – IOSCO Margin Adoption: A Further Rethink of Front to Back for the Buy-Side

Last month, the BCBS-IOSCO recommendations for variation margin exchange for non-centrally cleared OTC derivatives came into effect, impacting both buy and sell-side firms, with initial margin exchange being phased in to 2020.

David Field, Managing Director, The Field Effect

On Collateral Optimization in a time of constant regulatory change.

But rather than purely focus on back office readiness, firms must recognize the regulation’s rippling effect on bilateral trading operations in the front office.

At this critical juncture, a fundamental front-to-back operational shift is needed, not only to safeguard against risk associated with counterparty defaults, but to best fulfil investment objectives in an increasingly challenging market, where there is little margin for error (pun intended).

Whilst posting upfront initial margin and daily variation margin as a means of tackling counterparty risk is commonly used in cleared derivatives, its introduction in non-centrally cleared OTC derivatives is relatively new. Given the complexity of the change from both a documentation and operational standpoint, the regulation’s teeth will now not officially sink in to the market until September 2017. A welcome move, granting the financial sector the grace-period it needs to consider the technology systems in place and whether they can support this and future regulatory changes.

Though collateral management has traditionally been a back-office function, operating on a periodic basis, the new regulation will see it flooding into the front office’s daily workflow. In a recent poll conducted by SimCorp, one of the primary ‘pain points’ in collateral management, identified by buy-side firms, was increasing volumes. This is likely to surge, as pledged and received collateral will no longer be periodically exchanged in arrears and at high thresholds. Instead, asset managers will need to mark their books to market daily, and at much lower thresholds.

To add to these new and intensified volumes, trades with counterparties prior to and after 1st March 2017, could have not one but two margin calls, legacy and regulatory. In addition, whilst there is a general global consistency in implementation, there remains important regional differences, examples include the scope of covered products, such as deliverable FX trades, which are excluded from US regulation, and the treatment of non-netting and segregation jurisdictions.

A good majority of firms, including many of those responding to SimCorp’s poll, stated manual workflows and lack of automation as barriers to efficient collateral management, and this is further echoed in the recent SimCorp InvestOps’ Optimizing Front-to-Back Investment Operations report, where 61% of North American buy-side firms operate collateral management on a partially-automated or manual basis. Leaving aside the significant proportion of counterparty agreements that still need to be redrawn, the conditions within the regulation will only serve to continue the data explosion that firms are currently firefighting.

In this new world, front office investment decisions and collateral allocation are bound to be affected. Portfolio managers in the front office, will now need to consider collateral requirements in their OTC investment decisions, given the need to post margin. This includes the availability of collateral and the levels of, and timely access to liquidity in a portfolio. Therefore, a re-evaluation of investment strategies may be required, comparing the cost of a bi-lateral OTC investment decision with cleared OTC or exchange traded derivative alternatives. Furthermore, on the funding side, the need to access liquidity could increase the use of repurchase agreement (repo) markets, whether, bi-lateral, tri-party or cleared.

A change will also be seen in the way margin-call decisions are made. Asset managers in the front office will need to have oversight of what collateral i.e. cash and securities, is going out by way of pledge to counterparties, to make the most optimal investment decisions at any given time.

To enable the front office to make these best-informed decisions, and to fulfil their investors’ objectives successfully, asset managers need access to a timely overview of positions, cash and securities collateral and exposure. There is of course an operational burden in making this happen. But firms need to look beyond siloed short term fixes, and to operational change that transforms front, middle and back office technologies, on a single core platform, where one source of real-time data can traverse the whole office.

This article originally appeared on Fund Technology.