Understanding Initial Margin Requirements for Over-The-Counter Derivatives

Understanding Initial Margin Requirements for Over-the-Counter Derivatives Buy-side investors are seeing significant changes as new initial margin requirements for over-the-counter (OTC) derivatives take effect.

1 Following the 2008 financial crisis, Each CCP employs its own risk model regulators began encouraging the in determining initial margin requirements. The weighting of certain risk factors industry to clear more standardized may vary across CCPs, which can result products through central clearing in different margin requirements for counterparties (CCPs). The Basel otherwise identical deals.

Committee on Banking Supervision’s As an example, a portfolio of a single Uncleared Margin Rules (UMR) are fixed versus float swap at a notional value perhaps the latest example of of €10 million can generate very different margin requirements across CCPs, regulatory persuasion. depending on their tenor.

Market participants are more closely reviewing the costs and benefits of clearing — or not — Hypothetical Initial Margin Requirements certain derivatives transactions alongside UMR Tenor requirements. Just as CCPs require their clearing members to post initial and variation margin, 5 year 30 year

entities within scope of UMR also are required CCP1 164 910 to post both initial and variation margin for their impacted bilateral, uncleared activity. CCP2 115 1,012

UMR Phase V and Phase VI, which go into effect (Figures in thousands) in 2021 and 2022, respectively, will require more buy-side institutions to post and receive initial In the above scenario, placing the five-year margin in bilateral deals. OTC derivatives users swap at CCP2 is optimal, while the 30-year will face a series of decisions that can markedly swap would be best cleared through CCP1. affect their bottom line. In practice, asset managers will generally have a portfolio of multiple derivatives Cleared Transactions cleared with a CCP, adding complexity to Price and liquidity are typically the key factors the clearinghouse selection process. in selecting a CCP for cleared transactions. A new derivative transaction has the potential However, investors should also consider initial to either augment or offset existing directional margin requirements, given their potential risks in the portfolio. This can result in either impact to the transaction. a large incremental initial margin or a smaller, even negative, incremental initial margin.

2 In addition, managers must account for liquidity Similar to CCP initial margins, bilateral margin add-ons that CCPs may apply to larger, more requirements can sometimes be minimized concentrated positions. Managers who have by taking advantage of portfolio risk offsets accounts with multiple clearinghouses and if counterparties are chosen wisely. UMR also with multiple futures commission merchants allows for a minimum threshold. That means or clearing brokers face added complexity as if SIMM requirements are below a contractually each entity will apply different multipliers. agreed amount, there is no requirement to exchange initial margin.

Uncleared Transactions Regardless of whether trades are cleared The alternative to centrally clearing derivatives centrally or settled bilaterally, investors must is to trade them bilaterally, so long as regulators have pre-trade visibility into portfolios and the permit. Historically, this has shielded managers ability to estimate the effect of adding positions. from the costs and complexities of posting initial margin. The implementation of UMR Cheapest to Deliver will require more buy-side institutions to post initial margin on even their bilateral derivative While managing margin levels is important, trades. Most will calculate the requirement the ultimate goal is to minimize collateral costs. using the standard initial margin model (SIMM), Depending on eligible collateral and applied a risk-based portfolio margin model similar haircuts, whether at CCPs or in accordance with to what is typically used in CCP models. bilateral credit support annexes, a lower initial However, the underlying calculation methodology margin requirement may lead to a higher cost is notably different. SIMM calculation uses a of funds in some cases. For example, it is likely 10-day margin period of risk, while CCP models more costly to meet a margin requirement can apply shorter holding periods as brief as two of 95, where eligible collateral consists only days. As a result, assuming all other factors are of US dollars or US Treasuries than it is to meet alike, bilateral initial margin requirements will be a margin requirement of 100, where a variety higher than cleared initial margin requirements, of lower quality bonds, equities or ETFs often by a considerable amount. are eligible.

Put simply, managers must solve a multi-dimensional optimization problem to manage margin position and funding costs — before a cleared derivative trade is even initiated.

3 To be truly effective, ideal positioning as portfolios change and risk factors shift. Together, they form an end-to-end margin optimization must optimization framework that allows buy-side be accompanied by robust investors to: collateral optimization. • Make timely decisions on optimal trades • Minimize costs associated with sourcing Buy-side investors should use the cheapest-to- eligible collateral through upgrades or repos deliver algorithm across margin requirements • Maximize performance by unencumbering to achieve the most efficient and beneficial cash and high-quality securities for use transactional footprint. in securities lending or other investments

The Path Forward As margin requirements increase for buy-side Initial margin requirements introduce new firms, holistic optimization will be essential complexities and collateral costs that can to manage costs. At State Street, we believe be burdensome if not appropriately managed. this will become a differentiator in a highly Given the multiple dimensions of selection competitive asset management environment. criteria, robust pre-trade analytics, including Forgoing investment in optimization could cheapest-to-deliver methodologies, are critical leave managers overwhelmed with complexities in helping managers handle margining efficiently and saddled with unforeseen costs. and economically. Post-trade optimization Implementing a strong framework can create can suggest collateral substitutions, porting a competitive edge. of trades or other techniques to maintain

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