By Jacob Ullman, Associate Product Manager, Acadia
As regional bank stress and consolidation headlines surge, the need for proactive threshold monitoring for Initial Margin (IM) persists. IM, a form of collateral in financial transactions, acts as a safety net against potential future losses. Regulatory guidelines exempt firms from posting IM if their aggregate exposure remains below a $50 million threshold. However, even if under the threshold, Credit Support Annexes (CSAs) must be papered because any day exceeding the limit instantly triggers regulatory compliance requirements – a scenario that could materialize quickly during periods of financial volatility or bank mergers.
This narrative was driven by UBS’ acquisition of Credit Suisse, both of which are established firms from the early implementation stages of the Uncleared Margin Rules (UMR). The considerable exposure that comes with such consolidation demanded an in-depth analysis of the potential implications for similar M&A activity. This included consolidations between the Bank of the West and the Bank of Montreal, and US Bank with MUFG or Union Bank. These underscore the importance of such discussions in the context of the prevailing regulatory threshold. As these entities merge, the potential for collateral requirements grows. In extreme scenarios, the merger or acquisition between two firms could lead to a linear summation of exposure, bringing the regulatory threshold within immediate reach.
Navigating this dynamic financial environment where bank mergers can rapidly propel a firm towards the regulatory threshold requires a comprehensive understanding of global IM risk calculation standards, such as the Standard Initial Margin Model (SIMMTM). This method sums exposure within agreements non-linearly, thereby providing netting benefits. However, across agreements, the exposure is purely additive. Consequently, the consolidation of smaller IM relationships tends to follow the additive scenario and can unexpectedly push the aggregate exposure beyond the threshold, necessitating immediate compliance and imposing significant capital requirements. As such, prudent firms are utilizing proactive strategies to manage and optimize their IM exposure effectively.
The graph above shows the monthly rate of agreement breaches per IM phase, with both phase 5 and phase 6 gradually increasing over time.
In the context of bank mergers, it becomes essential to have a comprehensive overview of a firm’s IM exposure across multiple dealers. This allows clients to identify and strategically manage and monitor relationships that could potentially bring them closer to the regulatory threshold. Further emphasizing the need for forward-thinking measures to promote informed decision making regarding the maintenance, modification, or even termination of trades, thereby optimizing IM exposure throughout the complex process of consolidation.
While a proactive approach is highly encouraged, it is critical not to dismiss the potential need for retroactive situations. For example, firms might underestimate the rate at which a trading relationship could come under the scope of UMR. This underestimation could turn poorly supervised relationships into complex legal and collateral issues, as is pertinent right now with potential predicaments arising from the consolidation of UBS and Credit Suisse. Absent renegotiation of CSAs, the trading relationships from one firm do not combine with the other, meaning the netting benefits of this consolidation remaining unrecognized if they fall under separate agreements.
This scenario could thrust them beyond the $50 million regulatory threshold, necessitating immediate compliance. In a matter of days, firms might be compelled to draft new agreements, establish a system for calculating IM exposure, connect to a collateral system, and begin margin messaging. All these elements are crucial to ensure proper tracking of disputes and collateral flows. When done in a timely manner, firms could avoid mandatory regulatory dispute reporting requirements that are commonplace in new relationships, such as those in Phase 5 and 6 of UMR.
However, the reality is that most firms might not be adequately prepared for this rapid transition and could find themselves under the scrutiny of regulators. In the US, disputes exceeding $20 million over 20 days must be reported, thereby incurring additional costs. While this presents a bleak and daunting picture and represents a worst-case scenario, it’s a plausible outcome, especially when medium to large firms consolidate.
On a global scale, it is crucial to understand which products are in-scope for UMR. Though the computations remain the same globally, regulatory authorities have incorporated minor alterations, in accordance with local security laws, to dictate which traded products fall within the scope of the UMR. Therefore, a traded product that’s in scope in Japan or the United States might not necessarily be in scope in the EU.
The complexity of managing such consolidations across jurisdictions cannot be overstated. As firms globalize, the consolidation of trading relationships can increase the monitored figures if two books combine under different global regulators. Per UMR, the “worst-of” calculation is adopted, implying that for a given book or portfolio under multiple regulators, the highest exposure resulting from the most in-scope products is considered. Other subtleties in sensitivity calculations, such as index decomposition, may be critical to monitor or understand if applicable under the CSA. However, these details go beyond the purposes of this article.
With the long-standing presence of IM regulations, the need for threshold monitoring persists. By facilitating early warnings and transparency across all relationships and regulators, strategic decision-making is possible and paves the way for optimized risk management.
There have been requests for some allowances to be provided to firms who find themselves in this scenario. Regulators have so far rejected any industry-wide accommodation. Rather they have asked individual firms who are impacted to discuss with their regulator where necessary.
