All Eyes on March 1

From March 1, thousands of financial institutions will find themselves subject to new rules that will require them to exchange variation margin on their non-cleared derivatives trades. Four weeks out, the task of meeting that deadline looks as daunting as ever. In fact, it looks a probable that many firms won’t make it, raising the prospect they’ll be temporarily unable to access derivatives markets

This might come as a surprise to some. After all, the exchange of variation margin on derivatives trades is relatively common; many counterparties already do it. The complication is that the new rules set strict requirements on everything from eligible collateral to settlement timing, and these specifications need to be reflected in counterparties’ credit support documentation

This means modifying all existing agreements or setting up new ones – a monumental task made all the more difficult by the late publication of final national rules in some cases. And it can’t be done unilaterally: changes to each credit support annex (CSA) agreement need to be agreed by the other party

That takes time. There are a couple of ways firms might make those changes, but the preferred option for many at the moment is to bilaterally negotiate the necessary changes to existing CSAs and then to use those for both legacy and new trades. Given the variability in terms within existing CSAs, and the potential pricing impact a change in terms might have on a legacy portfolio, this approach is requiring manual intervention, analysis and discussion with each counterparty. And, for the larger dealers, those discussions will have to take place thousands of times, reflecting the size of their client base and the number of CSAs they have outstanding

The good news is that the industry, supported by ISDA, has mobilized its resources to meet the March 1 requirement. ISDA has provided solutions to help compliance, including a suite of margin-rule-compliant documentation. Awareness of the issue is improving, and firms are pushing hard to meet the deadline. The bad news is that there’s a finite legal resource to negotiate the changes, both within dealers and their clients – and those resources are stretched to the limit. There are just too many documents that need to change – approximately 200,000 – and too little time

While it is possible that some of the largest derivatives users may get enough done by March 1 to continue trading, albeit with fewer counterparties, it looks like many firms will not. Without regulatory action, those users may well be locked out of the derivatives market and unable to access the liquidity they need to hedge until they’re able to agree the necessary documentation changes with their counterparties. That could result in market disruption, fragmentation and pricing impacts

We think the answer is time-limited relief to give derivatives users the crucial extra months needed to get their documents in line with the requirements. Some regulators have already taken this approach. Hong Kong and Singapore, for instance, have introduced a six-month transition, during which in-scope entities will be expected to make progress towards meeting the rules. Regulators in Australia have also opted for a six-month transition, but with a requirement for all trades executed from March 1 to be subject to variation margin requirements by September 1.

ISDA is closely monitoring implementation progress, and we’ll feed that information to regulators regularly in the run-up to March 1. Dealers and their clients will continue to pull out all the stops to make the implementation deadline, but there simply may not be enough time.


Caution Required for Packages

It’s now less than a year until implementation of the revised Markets in Financial Instruments Directive (MIFID II), and European regulators are keen to nail down the last of the remaining policy details. One of the areas that looks close to being wrapped up is the transparency rules for package orders – but the proposed treatment, as it stands, could end up damaging the market for these important risk management tools.

Package orders combine several components – for example, a bond and a swap – in order to provide the end user with a tailored, specific hedge or trading exposure. By trading those components as a package, end users are able to achieve significant cost and execution efficiencies. While those benefits mean packages are regularly used as a whole, the fact each one can be so specific to a user means individual combinations might trade infrequently.

The fear is that these trades will become much trickier to execute under the proposed transparency framework. That’s because proposed rules published by the European Securities and Markets Authority (ESMA) in November would mean many highly bespoke and rarely traded packages are swept up in new pre-trade transparency requirements.

Why is this a bad thing? Simply, because requiring details of an infrequently traded product to be published before it is transacted is akin to a dealer showing its hand, giving market participants the potential to take advantage of that information. The end result would be greater execution risk and higher costs.

This, in turn, might force end users to abandon packages in favor of trading the components separately – a strategy that comes with more complexity and risk – or opt for simpler alternatives that do not exactly match their needs. In fact, European regulators themselves have accepted the negative consequences of a wide-scale pre-trade transparency regime for packages – which was what prompted the publication of the ESMA consultation on this issue.

We think ESMA should take a cautious approach, at least initially. For instance, we think it would be prudent to specify that a package should have no more than three components in order to be subject to pre-trade transparency requirements. All those components should be in the same currency, and they should come from the same asset class and sub-asset class (as specified under MIFID II). All the individual components should be liquid in their own right and should be traded on the same trading venue. Together, these changes will ensure that highly bespoke package trades that are unsuitable for pre-trade transparency will not get caught in the orbit of those rules.

It may be that once MIFID II is in place, and once ESMA has greater access to real-life data, these strictures might be relaxed, widening the pool of package trades that are deemed liquid. But, until there is more evidence, it would be wise to chart a conservative course to reduce the chance of market dislocation.

These technical recommendations may seem minor, but the effects of any misstep will echo far out into the market, possibly limiting end-user ability to perform legitimate and necessary risk management. The devil is in the detail, and these details will determine whether this market continues to function efficiently.