A new State Street survey finds that although the uncleared margin rules (UMR) represent a “monumental change” in the OTC derivatives industry, a large majority of the firms remain unprepared for the compliance as well as the operational challenges associated with the new workflows.
The bank says 81% of institutions with a September 2021 (Phase V) or September 2022 (Phase VI) deadline are unprepared to comply with all facets of UMR.
The survey measured the perceptions, plans and readiness of 300 asset managers and asset allocators in 16 countries around UMR, which were set in motion in 2008 to reform the OTC derivatives market following the global financial crisis.
“UMR signifies a major change in the industry that aims to bring greater stability and transparency to the OTC derivatives market,” says Nadine Chakar, head of State Street Global Markets. “As we approach the deadline for the next phase, it is critical for buy-side firms of all sizes to be aware of the pending requirements and to not only effectively manage, but optimise, their liquidity and collateral needs with the right solutions and technology in place.”
The survey found that roughly a year away from the next deadline, which was extended due to COVID-19, firms remain primarily unprepared for the different aspects of the regulation. It finds that institutions are in different stages of compliance preparedness by both phase and function and that the vast majority (86%) are preparing for Phases V or VI, representing the significant proportion of buy-side firms coming under the purview of UMR in the next two years. “These institutions face a steep learning curve as many are unfamiliar with Initial Margin (IM) rules and operations,” State Street says.
For those firms in the preparation stage, only 19% say they are fully prepared for compliance, while 42% are preparing in all relevant functions, while the remaining 39% have begun preparations in just a few areas. Nearly 8 in 10 have not agreed on how to approach settling segregated collateral with counterparties.
As it stands, third-party custody with account control agreements remains the favoured approach amongst respondents, although State Street says many firms underestimate the difficulty associated with compliance with UMR. While 68% of those preparing for compliance are very confident in their ability to handle the new workflows, 80% of those in compliance said they faced challenges in incorporating them.
As institutions continue toward the compliance stage, half expect these requirements will ultimately have a positive impact on overall operations, while 40% of the smaller firms surveyed anticipate a negative impact, compared to just 20% of larger firms. Public pensions were most likely to expect a positive impact, while corporate pensions were most likely to anticipate a negative impact.
Institutions are using mitigation strategies and have turned to third parties to ease the burden of complying with UMR with 80% of those in compliance functions indicating that they have faced some degree of challenge in incorporating new workflows. To ensure on-time compliance, the majority of firms are employing a mix of in-house capabilities and outsourcing to third parties with operational expertise.
Finally, 56% of firms are planning to adjust strategies by reducing OTC contracts to limit the impact of UMR. For those already in compliance, 80% reported a reduction. The majority are using compression strategies to limit UMR’s impact and the bank says firms will seek various optimisation strategies with third parties.
“The key to any regulatory compliance is to look at all the requirements and objectives holistically,” says Gino Timperio, head of funding and collateral transformation at State Street. “While it’s tempting to circumvent the complexity of UMR by simply reducing the volume of in-scope contracts, I’d argue this approach is short-sighted. Recent market volatility underscores the need to consider collateral, funding and liquidity at a firm-wide level, and buy-side firms should adopt a strategic approach to UMR compliance, with the right external support to manage some or all components of the process.”