The way collateral is posted or collected as initial margin (IM) for over the counter (OTC) derivatives¹ has changed significantly in the last few years. New updates will bring even more change.

From May 22, 2024, the U.S. Financial Industry Regulatory Authority (FINRA) rules for margin amendments will require clients to pledge initial, and potentially, variation margin, to brokers as part of trading in a defined subset of securities known as “covered agency transactions”. These include collateralized mortgage obligations (CMOs) and mortgage-backed securities, which are generally traded on a to-be-announced basis.²

The rules target covered agency transactions, the scope of which FINRA has indicated as including:

• To Be Announced (TBA) transactions, inclusive of adjustable-rate mortgage (ARM) transactions, for which the difference between the trade date and contractual settlement date is greater than one business day.
• Specified Pool Transactions, including agency pass-through mortgage-backed securities, for which the difference between the trade date and contractual settlement date is greater than one business day.
• Transactions in Collateralized Mortgage Obligations (CMOs), issued in conformity with a program of an Agency. These can also be transactions in Government-Sponsored Enterprise (GSE), for which the difference between the trade date and contractual settlement date is greater than three business days.

These adjustments build on more wide-ranging Uncleared Margin Rules (UMR) which took effect in the U.S. and EU in September 2022 for the buyside, particularly asset managers and pension funds.

The scope of FINRA Rule 4210 and Uncleared Margin Rules (UMR) is immense: the International Swaps and Derivatives Association (ISDA) estimates that more than 775 counterparties with an excess of 5,400 relationships are subject to IM requirements.²

To understand the impact of UMR, let’s look at the journey to regulate derivative instruments so far.

The Road to Increased Regulation

The 2008 global financial crisis demonstrated that many derivatives transactions executed bilaterally were uncollateralized or under-collateralized. Policymakers concluded that these bilateral transactions increased the financial system’s interconnectedness and the lack of centralized information on OTC derivatives transactions contributed to uncertainty over counterparty exposures.

Several new regulations were introduced, creating a significant impact in changing the collateral landscape. These include:

• The European Market Infrastructure Regulation (EMIR) - lays down rules on OTC derivatives, central counterparties, and trade repositories.
• The Dodd-Frank Wall Street Reform and Consumer Protection Act (the Dodd-Frank Act) - title VII Act contains the U.S. framework regulating OTC derivatives (swaps), including its G20 commitments for the reporting, clearing and exchange trading, as well as margin requirements for non-cleared swaps.
• Basel III - addresses the capital and liquidity requirement of banks and pushes them towards centralized clearing of their OTC derivative transactions.

The shift to central clearing and margin requirements for non-cleared derivatives transactions therefore was intended fundamentally to decrease counterparty credit risk. Margin requirements for derivatives transactions that would remain uncleared were supposed to reduce counterparty risk by ensuring that collateral is available to offset losses caused by a counterparty default in bilateral transactions.³

Implementing UMR

U.S. prudential regulators and European regulators first introduced IM rules for non-cleared derivatives in 2016 as part of financial reform initiatives. The rules were rolled out with a phased implementation timeline. The Basel Committee on Banking Supervision (BCBS) and the International Organization of Securities Commissions (IOSCO) agreed to the following:

• Minimum standards for margin requirements
• Standardization of initial margin calculation methodology
• Grid (a table-based methodology)
• Standard Initial Margin Model (SIMM)
• Initial margin exchange guidelines.

The first five phases of implementation of IM rules have had a limited direct impact to BBH’s clients due to their aggregate average notional amount (AANA) of non-cleared derivatives⁴ not meeting the established thresholds. With the final phase of implementation, and with the thresholds reducing to USD $8billion, BBH expected more of its client base to be impacted by the IM requirements (see implementation plan below).

As mentioned above, the last phase took effect in September 2022 when the buy-side was impacted significantly. Following that implementation date, many non-cleared swap counterparties were required to post and collect initial margin to meet the regulatory requirements.

While the UMR focuses on derivatives, it also impacts securities lending participants, especially those on the buy side. In this case, buyside firms must utilize securities lending programs to substitute and enhance their collateral. They need to access collateral that is eligible for IM and ensure their counterparties agree regarding the type of collateral that will be made available.

Spot and physically settled forward foreign exchange forwards do not fall within the scope of UMR, but this does not mean the rules have no effect on traditional FX business. FX forward exposures count towards a client’s AANA threshold calculation together with other kinds of FX exposures. In view of the impact to OTC FX activity, many firms are considering switching to cleared arrangements.

The UMR also impacts post-trade services providers: the regulations require the posting and segregation of IM for non-cleared derivative transactions at an independent third-party custodian or tri-party agent.

Historically, the pledge-and-release process has had many operational inefficiencies, but the industry has been making strides in bringing solutions to the market to provide automation and scale opportunities. There are increased pressures to open and maintain collateral accounts at custodians or third-party entities in a timely manner while also working to streamline the negotiation of Account Control Agreements (ACAs) between clients/asset managers, custodians, and broker/dealers. In addition to the need to open and manage new collateral accounts, there are increased cash and securities movements, compressed settlement timelines and a greater demand on same day settlements.

What Should Clients Do to Prepare?

Clients should be taking the following steps to ensure preparedness:

• Analyze your derivatives portfolio to identify the trades that will be subjected to the new margin rules.
• Calculate your Aggregate Average Notional Amount to determine implementation date and self-disclosure.
• Ensure the model used is scalable as counterparties will be subject to periodic stress testing.
• Determine tools and technology you will employ for IM Calculations: SIMM or regulatory tables (grids).
• Ensure collateral management operational teams are equipped to manage your IM needs and the proper operational infrastructure is in place or being developed to optimize collateral.
• Determine the best collateral operational model to support your business (i.e. Third-Party Collateral Accounts, Tri-Party Collateral Agents, MT527 messaging).
• Work with your counterparties to determine which custodian will be used to post and hold initial margin.
• Determine if you will use cash as collateral and work with your custodian to understand capabilities to invest cash into overnight vehicles to minimize/diversify credit risk.
• Work with your custodian to identify the number of new collateral accounts that will need to be opened and ensure your designated custodians can support.
• Negotiate new (or update existing) Account Control Agreements as needed.

What is BBH doing to Prepare and Assist Clients?

BBH continues to support clients with margin readiness by opening several collateral accounts for fixed income managers to balance the margin requirement needs. The expectation is that any/all margin requirements are reviewed by clients and instructed to the relevant segregated account(s). Then, when the collateral is no longer required, the investment manager will coordinate with the secured party to facilitate the release of cash/security collateral.

BBH has also made changes in the following areas:

• Improved the collateral account set-up process to create efficiencies, build scale, and minimize delays associated with collateral account setup.
• Prepared standard templates – in conjunction with broker /dealers where applicable - to be used for the agreement negotiation.
• Streamlined the management and maintenance of standard settlement instructions (SSI) details for both standard accounts and collateral accounts by onboarding clients to the Global Custodian (GC) Direct utility. The automated interface with GC Direct greatly decreases fail rates and improves settlement timeliness.
• Invested in the development of an internal collateral tracking facility to help manage the capture and reporting of collateral transaction details.

The firm anticipates needing to support multiple collateral operating models based on decisions made by our clients. We currently see the need to support two different instructional models:

• SWIFT MT527 messaging⁵
• Tri-party collateral agents

BBH supports clients and their counterparties who choose to use SWIFT MT527 messages for the pledge-and-release process. The MT527 message provides an alternative to fax, which tends to be the current process still used by many to instruct a release of collateral. The MT527 would be used by the secured party to instruct the release of collateral back to the pledgor. This provides market participants another way to manage the pledge-and-release process.

BBH has seen an increase in client and broker inquiries regarding the ability to support MT527 messaging and anticipates seeing more clients adopt this message standard. The MT527 message is not widely used in the industry today and there is still work to do from an industry standardization perspective to fully support and automate the release authorization associated with the MT527 message to match the MT527 to the corresponding client instructions.

Lastly, asset managers may elect to use a tri-party agent. If a client chooses to use a tri-party agent to manage their collateral/initial margin processes, BBH will work directly with its clients to build connectivity with the specified tri-party agent to ensure the books and records at BBH accurately reflect what is in BBH’s custody versus that which is held at a tri-party agent. Tri-party agents act as an independent collateral agent to manage the collateral lifecycle.

Additional Reference Tools

• ISDA’s checklist
• ISDA documentation material
• SIFMA Initial Margin documentation