A fundamental change in how financial institutions are dealing with credit risks

By Etienne Ravex | 30 September 2015

Over-the-counter (OTC) derivatives were identified as one of the main scapegoats of the 2007/2008 financial crisis. The G20 group, amongst others, suggested that all standardised OTC derivative contracts should be cleared, and that non-centrally cleared OTC derivatives should be held accountable for margin requirements.

In 2013, the Basel Committee on Banking Supervision (BCBS) and the International Organization of Securities Commissions (IOSCO) defined a policy framework for margin requirements for non-centrally cleared derivatives. The main objectives and benefits of this framework were a significant reduction of systemic risk in the market with the mandatory exchange of both initial margin (IM) and variation margin (VM). Margin is a defaulter-pay risk mitigation function, and has been preferred to capital, which is survivor pay. Margins are thus expected to give better incentives to market participants to better internalize the cost of their risk taking.

In Europe, the European Supervisory Authorities (ESAs) have drafted technical standards for the implementation of these rules under the EMIR regulation Article 5. All types of non-centrally cleared OTC derivatives are affected by the new rule for IM exchange, apart from physically settled commodity derivatives.

All financial firms and systemically important non- financial firms who are involved in trading OTC derivatives are subject to these margin requirements. In their second consultation paper (published in June 2015) the ESAs finally exempt non-EU non-financial entities that are below the clearing threshold from non-cleared margin requirements.

Requirements to exchange margins in the European Union will abide by proposed international timelines. Large financial firms are obliged to comply from September 1, 2016, with a 4-year phase-in period for smaller firms.

IT systems play a key role in helping institutions rapidly adapt to this ever- evolving regulatory environment. In particular, they are critical in the following areas:

  • Support for various possible margin models along with real-time trading decision support
  • Implementation of robust operational procedures to drive efficiency, reduce operational risk, and ensure documentation will be available in a timely manner
  • Risk control procedures to comply with concentration limit requirements

Multiple margin models need to be supported

From a computation perspective, the challenge is concentrated around IM rather than VM. ISDA is strongly pushing for a standard model, but there are still uncertainties around the final framework. In this context, systems need to be able to support possible competing models, including:

  • A standardised, schedule-based model with a full representation of regulatory add-ons
  • IM models based on VaR capabilities
  • ISDA SIMM
  • Or any new model similar to SA-CCR that may arise

These capabilities must be brought together at an aggregate level for the generation of IMs. Systems can add greater value by incorporating real-time incremental margins metrics into the trade decision-making process.

Robust operational procedures

These regulatory changes place collateral management at the forefront. Collateral management departments will need to leverage their core competencies in operations management to cope with multiple challenges:

  • An exploding number of margin calls to be processed on a daily basis
  • Compliance with new operational procedures
  • Onboarding of new agreements while managing legacy contracts

Margin call volumes are expected to dramatically rise by 2020 when the regulation will be fully phased-in. An increasing number of agreements will be signed, with zero-threshold VM exchanged on a daily basis and IMs.

Therefore, systems need to bring value and efficiencies by providing automation along the full lifecycle of margin calls. This represents an important shift from manually intensive work based on e-mail communication, to a higher level of automation leveraging electronic messaging standards.

Systems are key enablers

Margin requirements for non-cleared derivatives pose a series of challenges by further increasing the cost of doing business in OTC derivatives markets, while bringing more stability and shifting credit risks from survivor to defaulter. Systems can act as a key enabler to help institutions face these challenges by better monitoring trading costs and implementing regulatory requirements. This requires a unified infrastructure to overcome inefficiencies and fragmentation arising from legacy systems.

Authors and Editors:

  • Etienne Ravex, Collateral Management Product Manager, Murex
  • Farid Rahba, Pre-Sales Enterprise Risk Management, Murex
  • Thomas Schiebe, Business Consultant, Sapient Global Markets
  • Thomas Schiebe, Business Consultant, Sapient Global Markets

 

Download the full white paper by Murex and Sapient here

To learn more, please visit www.murex.com or follow us on LinkedIn and Twitter @Murex_Group.

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