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Buy-side faces tough year
of collateral reforms

If you’re in the over-the-counter (OTC) derivatives market the chances are that early 2017 is going to present some considerable challenges for you, especially if you’re on the buy-side. Some of the tasks will be new, some more familiar, but in all cases they will be tackled most effectively with one eye on the long-term outcome.


By now of course, the OTC derivatives market is no stranger to the tactical and strategic challenges of meeting regulatory compliance deadlines whilst getting on with business. Since the US was first out of the blocks in responding to the G20 reform mandate via the 2010 Dodd-Frank Act, new rules on reporting, clearing and related processes have become a constant presence.


In that respect, 2017 will not be much different. 2016 has seen large buy-side firms begin to centrally clear interest rate swaps under the European Market Infrastructure Regulation (EMIR) while global swap dealers have started to exchange Initial Margin (IM) for non-cleared OTC derivatives in line with US and Japanese introduction of a framework set out by the Basel Committee on Banking Supervision and the International Organisation of Securities Commissions (BCBS-IOSCO). 2017 has kicked off with the European launch of these IM rules in February and will also extend EMIR’s central clearing mandate to 'category 3’ firms, essentially counterparts with smaller derivatives volumes than category 1 and 2 entities, in June.


But it is March that should be circled in red on the 2017 calendars of every OTC derivatives market participant. Why? March brings the all-but-universal requirement for exchange of variation margin (VM) between counterparts to non-cleared transactions, with virtually no exceptions by size or geography, as outlined by BCBS-IOSCO. Compared to other OTC derivatives market rule changes since 2009, the VM rules are in large part neither complex nor controversial, but they do represent a new departure, especially for smaller buy-side firms, particularly those that have not previously needed to collateralise a swap transaction.


There are pros and cons to being the latest in a long line of compliance deadlines. On the upside, considerable expertise and options have been developed in recent years to enable firms to mobilise and transfer collateral in a cost-efficient manner. Industry-wide working groups have shared best practice; utility-type solutions have emerged from collaborative consultations to augment in house-capabilities; banks, technology vendors and market structure operators have adjusted and upgraded their services.


The tools exist to handle March’s 'big bang’, but the challenge could be accessing the right ones for particular needs in a timely fashion. The downside to the busy compliance calendar is limited bandwidth, not only to make necessary internal changes but to negotiate and test new contractual arrangements and processes with counterparties. Even though September’s IM rules only directly impacted a handful of well-resourced, relatively homogenous global swap dealers, the effort needed to implement new margin models was so intense as to push other priorities aside. This is a concern when one considers the number and variety of firms that will need to facilitate VM exchange in barely three months’ time.


In this context, starting early may have not been an option, for example if you’re a relatively infrequent user of non-cleared swaps and a customer of a large broker-dealer looking to prioritise resources to its most important customers. Any constraints among counterparts will undoubtedly cause frustrations, but there are resources to be called upon and initiatives to be taken to ease the transition to the new environment. Effective VM compliance will be based on visibility of collateral resources and margin obligations as well as the process efficiency in the mobilisation, exchange and monitoring of collateral. Much of this can be achieved by strengthening and re-engineering existing practices, with reference to the industry’s efforts to provide common methodologies, as well as utility and outsourced solutions that avoid the need for extensive internal IT development. The buy or build paradigm has shifted to one where industry-standard resources can be rented according to need, with the advantage of automatic adherence to best practice.


Such options have the potential to meet long as well as short-term needs. With any compliance project, a constant concern is that the efforts required to meet the deadline may not offer the best support as new priorities emerge. Inevitably, all firms will have to undergo a cleaning-up exercise to fine-tune new processes to handle day-to-day market realities.


Some are looking to meld the operational processes required to support cleared and non-cleared OTC derivatives together, while others may go further, creating a common collateral model across derivatives, repo and securities financing. Regardless of scale, such post-compliance refinements will likely run more smoothly if the initial project takes account of the process standardisation and collaboration undertaken by the industry in recent years. Deadline stress may be inevitable in 2017, but there are opportunities to build for long-term success too.