The initial margin challenge – Why the bang just got bigger

With uncertainty abounding as the industry heads into the final phases of implementation of the uncleared margin rules (UMR), Jean‑Paul Botha, delivery lead of financial trade documentation at Thomson Reuters Legal Managed Services, explores the challenges the industry faces and how technology and early preparations will be key for in-scope organisations

Jean-Paul Botha, Thomson Reuters

It has become increasingly common to hear how worried the market is about the final two phases of UMR, which will come into effect in September 2019 and 2020. The International Swaps and Derivatives Association’s (Isda’s) recent white paper, Initial margin for non-centrally cleared derivatives: Issues for 2019 and 2020, helpfully details many of the challenges and outlines initial findings from an ongoing quantitative exercise, assessing volumes of new in-scope counterparties over the next two years. This suggests more than 1,000 new counterparties could come into scope over phases four and five, and this estimate is likely to increase as data is gathered from the market. Compared with the 40 to 50 organisations that participated in the initial three phases, this number seems daunting. However, while the white paper outlines some specific “work that needs to be done”, it falls short of actually sizing the effort required to become compliant.

Thomson Reuters’ analysis suggests the documentation challenge alone is likely to be at least of an order of magnitude greater than has ever been faced before. Using detailed time-tracking data from UMR negotiations that Thomson Reuters’ Legal Managed Services supported across the first three phases – combined with discussions with currently in-scope organisations and estimates of 2019 and 2020 new counterparty volumes – the industry will need to engage in 12 to 15 times more ‘documentation man hours’ over the next two years than what was required over the past three. As a group, in-scope organisations are likely to require almost one million man hours to agree and implement all of the required legal components.

 

Solutions

The extent of this challenge – and the pressure it will put on legal and documentation teams and their service providers – will be unprecedented. Unsurprisingly, those likely to be hardest hit – large broker-dealers – have been looking to all corners for solutions that could reduce the burden. To this end, two technology platforms offering end-to-end initial margin (IM)-specific solutions have emerged:

• Margin Xchange – a joint venture between SmartDX, IHS Markit and Allen & Overy
• Isda Create – a partnership between Isda and Linklaters.

These platforms, both likely to develop further, have been actively engaging with the market. Thomson Reuters found they could reduce the effort required in 2019 and 2020 by up to 35%.

The Legal Managed Services data on which the analysis is based breaks down IM documentation negotiations into more than 70 distinct sub‑activities across the following categories:

• counterparty outreach and reconciliation
• eligible collateral profile reconciliation
• custodian documentation 
• credit support annex/collateral transfer agreement /credit support deed negotiation
• post-execution activities 
• ongoing file maintenance and admin (to support management reporting, for example). 

The model was flexed to account for variability in the documentation process, as well as in the potential impact of technology on each sub-activity. A negotiation process that incorporates minimal automation – in effect, limited or no use of document generation tools, outreach platforms, e-signature and data extraction technology – was used as a baseline. For organisations that have already aggressively adopted supporting technology, savings will not be so great in percentage terms, but should still be material. 

 

Challenges to adoption

However, some caveats apply: most importantly, if adoption is patchy the industry will not be able to fully reap the rewards. It’s possible larger broker-dealers will be enthusiastic adopters of both platforms to offer their counterparties maximum flexibility while driving efficiencies for themselves. There will be challenges with this approach – unification of contract and negotiation databases and reporting, for a start – but the time savings should more than offset this at scale. There will also be corollary benefits to adopting negotiation platforms rather than the traditional exchange of documents in Microsoft Word format, such as detailed audit trails. Finally, the ‘on-or-off’ platform negotiation capabilities that both solutions expect to offer will also be critical if the buy side is reluctant to adopt. This will be particularly relevant in 2020, when newly in-scope counterparties may have less appetite for new platforms given their relatively low volumes.

In conclusion, the final phases of IM present an unprecedented challenge to the industry. Technology can mitigate this to a significant extent; the documentation challenge could be reduced by up to 35% by Margin Xchange and Isda Create. But even if these savings are realised – and adoption is still uncertain – the size of the task remains enormous: five to ten times greater than the first three phases of UMR. For that reason, making early preparations in relation to all aspects of the final phases of IM is clearly crucial for all in-scope organisations. Without it, market participants risk a modern tragedy of the commons: each individual organisation running down the shared resource of time only to find themselves subject to significant trading disruption, largely of their own making.

About the author

Jean-Paul Botha is the delivery lead for financial trade documentation at Thomson Reuters with more than 10 years’ experience in providing negotiation services and developing legal managed service solutions in the finance-related documentation space.

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Thomson Reuters Legal Managed Services provides alternative legal services, including financial trade documentation, contract management, managed discovery, document review and advanced litigation services, and regulatory change management. Its solutions help global financial institutions prepare for current and new regulatory requirements including uncleared margin rules, the revised Markets in Financial Instruments Directive (Mifid II), Brexit, interest rate benchmark reform and Securities Financing Transactions Regulation.

 

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