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Phase 6 of UMR Will Be a Game-Changer in Derivatives

Phase 6 of UMR is just around the corner. Here’s why it will be a game-changer in the derivatives market

By Joseph Spiro, Hazeltree

Seasoned derivatives traders know that new and more stringent uncleared margin rules have reached deeper into their industry. Coming late summer of this year: Phase 6 of UMR implementation, an expansion of UMR regulation into a new tier of firms.

You could call it the long tail of the regulatory backlash to the financial crisis: the new rules are all about helping to mitigate systemic risk of derivatives exposures. U.S. regulators, through the CFTC, along with global regulators, have moved largely in lockstep in both architecting and rolling out the regulations. With each new phase, more firms fall “in scope” and have to comply with initial margin rules, monitor average aggregate notional amount (AANA) levels and more rigorously codify counterparty relationships. Phase 6 will affect a much wider group of asset managers and counterparties by lowering the AANA threshold to $8 billion to be in-scope.

The outstanding questions, which become more pressing with every passing day, include who, exactly, is in scope. There also are multiple variations of “what” questions, including:

  • What needs to be done to comply with Phase 6?
  • What is the actual timeline required to prepare (given how much work is required and the very limited resources available to outsource)?
  • And importantly, “so what?” What’s the worst that can happen if the Phase 6 deadline comes and goes? There’s a plot twist: It’s not the regulators that pose the biggest threats.

Although September 2022 may seem far off, in regulatory terms it’s right around the corner. Preparation requires work on many fronts and should begin immediately for firms to be ready for September. There’s a lot at stake, for the consequences for not being prepared for Phase 6 could be severe, as noncompliance could curtail or even cut off trades.

For firms that fall in scope, Phase 6 also promises to require a new level of nimbleness and coordination with their back office to meet compliance standards and reduce costs. As such, derivatives trading for a new swath of hedge funds, other asset managers and their counterparties soon will enter the threshold of a new and more demanding era.

What needs to be done to comply?

Regulators have incrementally implemented Uncleared Margin Rules governing OTC derivatives trading collateral in the aftermath of the 2008 financial crisis. Now those funds that fall in-scope will require both trading parties to post initial margin that is held in segregated accounts. The rules also prescribe how margin is calculated and what types of collateral can be used.

Managers need to answer several questions:

  • Are we in scope? (AANA calculation required)
  • How will initial margin change?
  • Do I have the right service providers lined up?
  • Are counterparties informed?
  • Have we explored options to mitigate or avoid the impact of the rules?

What’s the timeline? Preparation takes longer than you may think

There’s a reason that regulators outlined a protracted implementation period for UMR compliance — it takes a considerable amount of time to prepare for these rules. Just the data management component, to load positions into a database and normalize the data to even enable ANAA calculations, is very heavy lift for most firms without sophisticated IT resources.

Compliance also demands that firms determine their initial margin requirements with their swap dealers using either Grid or the risk-based SIMM methodology, which has its own complications and nuances. An array of service providers – lawyers, technology vendors, and custodians – also need to be lined up and consulted, and anecdotally significant bottlenecks are already beginning to form that could make the deadlines seem more imposing even at this early stage.

There’s more: Assuming a fund doesn’t create a workaround to either reduce their ANAA or initial margin — to get below the $50 million threshold — many will also seek to consolidate their uncleared OTC positions to minimize the number of segregated collateral arrangements needed.

When it’s all said and done, a back-of-the-napkin estimate might arrive at an 18-month timeline if the back office isn’t able to pursue parallel paths on the necessary steps. 

The “so what?” What could go wrong?

For firms that fall in-scope, the net effect will be far more attention to regulatory detail and the costs they entail. Failure to prepare is not an option for managers: swap dealers, who face rigorous regulatory scrutiny, won’t do a trade without proper counterparty compliance.

But even to design a workaround requires that fund managers put in place processes and tools to manage their AANA in real time to avoid falling into the scope of UMR regulations without realizing it. Firms with real-time awareness will be rewarded, in some cases by reducing risk and staying below regulatory thresholds.

Why Phase 6 is a game-changer for derivatives trading

Phase 6 represents a brave new world of derivatives compliance, one that favors firms that manage it aggressively. Beyond the extensive preparation it requires, Phase 6 will elevate some back-office functions involving collateral and AANA. Phase 6 brings a new premium to trading efficiency: Managers without real-time awareness of the new financial implications of trades may unduly burden their firms’ bottom line.

Joseph Spiro is a Director of Product Management at Hazeltree. He has been part of the Collateral Management industry for over 20 years. Prior to joining Hazeltree, Joseph held the position of US Head Collateral at Société Générale, where he was one of the principal members of the dealer community responsible for ushering in UMR phase 1 in 2016, as well as subsequent phases. Prior to SG, Joseph held leadership positions at Merrill Lynch, Deutsche Bank and BNY Mellon. Joseph has contributed to ISDA and other industry working groups on the topic of collateral management and has been a contributor to ISDA publications in the field of collateral management. At Hazeltree, he is focused on helping Hazeltree’s buy-side clients to improve their collateral management process, to increase efficiency, reduce risk and increase liquidity.

Joseph holds an undergraduate degree in Economics from Rutgers University, and a Masters in Business Administration from New York University Stern School of Business.