Kate Lowe, global head of trade services at State Street, talks to Profit & Loss about how new margin requirements could shape buy side behaviour in the FX market, and why 2019 is likely to be a “staging” year for many of these firms.

Profit & Loss: As you’ve been talking to clients at the start of 2019, what’s been the major areas of focus for them?

Kate Lowe: Well one of the big talking points at the moment is the impact that the uncleared margin rules (UMR) are going to have on the industry. In September this year, the threshold for firms that have to post initial margin for uncleared swaps, including FX forwards and FX swaps, lowers to include anyone that trades an aggregate notional daily amount of $750 billion or over of these products. This will be the first threshold to really capture some of our buy side clients, and then in September 2020 this threshold lowers again to $8 billion, which means that significantly more firms will be impacted.

As a result, clientsand in particular, the asset management community are looking for solutions to help validate their margin requirements and effectively manage the payment of that margin on a daily basis. Some clients are also looking at central clearing, we’ve already seen uncleared margin rules push more interbank NDF trading towards clearing, and as these rules push out to the buy side there is speculation that it will encourage more asset managers and hedge funds to clear too.

Then the other solution that some clients are evaluating is whether they should be using some form of intermediary services. In the past, the asset manager community has never needed to use a prime broker, whereas now in some cases consolidating their portfolio and centralising any margin payments with a single prime broker, or even two, might save them a significant amount from an operational perspective, as well as a processing and cost perspective.

P&L: Do you feel that these clients are well prepared ahead of the UMR, or is there a sense of panic creeping in as the next threshold deadline approaches?

KL: The clients that we’ve been speaking to are taking a fairly pragmatic approach to this, they’re still evaluating their portfolios and figuring out what the best solution for them will be. Because a lot of this is going to be driven by economic and cost incentives, it might not be as pressing as some other items on these firm’s agendas and therefore I think that 2019 will be a staging year for a lot of buy side firms. 2020 is when we’ll start to see a real change in behaviour.

P&L: You mentioned that some asset managers might start looking towards FXPB services. One of the issues often mentioned that complicates this is that if asset managers started using FXPBs for existing clients they would have to re-paper their agreements with those clients, something that they’re reluctant to do. Is that an issue that you hear about?

KL: Yes, I’ve heard the paperwork discussion. But one of the big drags on resources for firms that continue to trade bilaterally after the UMR hits is that they’re going to be re-papering under a new margin methodology anyway. These firms will need new ISDAs with all of their counterparties, so they might be chasing 20 or 30 counterparties on that front, and then they need to have an external, independent custodian who holds the margin and so they have to set up those arrangements too. I think that a lot of clients know that they will have to post margin but are still assuming that otherwise everything will remain relatively the same. The reality is that whatever response they choose to the UMR, it will involve a lot of work, including if they stay bilateral and keep counterparties as direct interfaces that they post margin to.

Another point that I heard discussed recently that really resonated with me is that once the UMR kicks in, if for some reason a firm caught up in the requirements fails to post margin when they should have, that’s a regulatory infringement and that will need to be reported to regulators. That’s a big change, because right now even clients that have already been posting margin have a lot of flexibility with their existing bilateral ISDAs there are grace periods, there is time allowed to dispute any issues, and because of their existing relationships the banks will often give these clients a bit of leeway. Once UMR kicks in, failure to meet your margin obligations isn’t just an issue that needs to be resolved with a counterparty, it’s a regulatory issue. And that’s going to be quite revolutionary I think, because while the banks are used to this level of regulatory scrutiny, the buy side is not.

P&L: So then is the real driver for clearing or using an FXPB gaining efficiencies or avoiding punitive regulatory action?

KL: So some firms might opt to clear some of their transactions just so they fall back under the threshold and they’re no longer captured by the UMR rules and therefore don’t need to post margin. However, just clearing some of the NDFs in your portfolio whilst settling the rest bilaterally can add a lot of operational overheads, and so some asset managers that we’re talking to have confirmed that if they’re clearing for one fund they want to do it for all of them in order to streamline their processes and maximise their operational efficiencies. By contrast, using a prime broker won’t help firms avoid UMR because even if you centralise your trades through a PB, those trades will still be counted towards your uncleared margin threshold.

Ultimately, what solution a firm opts for will vary based on their portfolio, how they’re trading FX and what instruments are complementary to the netting benefits they’re getting. It’s also worth noting that some CCPs will only support certain products, while prime brokers will probably support the whole of your FX portfolio. But then on the technology side, the PB industry has historically struggled to cope with the magnitude of allocations and the post-trade processing associated with asset managers.

I don’t believe that there’s going to be any one hard and fast solution to all of the problems facing clients following the next lowering of the UMR threshold. Interestingly though, we are hearing more noise from clients in the US than Europe regarding central clearing.

P&L: Really?

KL: Yes, anecdotally some US clients are saying that OTC clearing has worked successfully for them in the past and therefore they’re going to roll up FX clearing into that and clear as much as they can to avoid falling under the UMR. In fact, the US clients that I’ve spoken to are very savvy and on top of the changes that are happening, they’re doing careful evaluations right now and some are looking to do test trades as soon as July.

P&L: What’s driving this disparity? Is it just because firms in Europe have been so focused on MiFID II compliance that they’ve paid less attention to the upcoming changes in UMR thresholds?

KL: Absolutely. I think that MiFID II was a huge lift for a lot of firms; people are still working to implement the best execution and TCA requirements contained within it, so I think there’s still definitely a MiFID II hangover. Brexit is also a genuine distraction for these firms in the European market, so firms are focused on imminent challenges and are staving off UMR till 2020.

Honestly, I think that people have been fighting to keep their heads above water the last couple of years and they simply didn’t have the time or resources to dedicate to this issue. This is why I say that 2019 will probably be a staging year for a lot of buy side firms, and we’re going to see the actual implementation of some of the interesting and innovative solutions that are out there in 2020, or even 2021. That’s when most people will raise their head above the water and start to focus on innovation versus optimisation.

Galen Stops

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