If you work in financial markets, March 1st was supposed to begin a sea-change for margin requirements. The Commodity Futures Trading Commission (CFTC) was set to start enforcing sweeping new regulations designed to prevent another derivatives market crash that peaked in 2008.
The rules require OTC Derivative trading firms to better monitor their risk exposure and post cash or other forms of collateral to cover day-to-day swings in market prices as a way of ensuring that trading institutions aren’t over-leveraged. But unpreparedness across the market gave way to a last minute reprieve.
Regulators announced a “no-action” grace period in response to overwhelming “operational challenges” facing approximately 90% of the market. We’ve been working with some of the banks that were prepared to meet the deadline with Perceptiv solutions & implementations.
Avoiding the next big short
The $544 trillion derivatives market was largely unknown to the general population prior to 2008, when the market crashed and kicked off a worldwide recession. Years of news coverage and Michael Lewis’ fantastic book turned movie The Big Short have created a pretty good general awareness in the meantime.
For the uninitiated, derivatives contracts are financial products that derive their value from an underlying asset, for example mortgage loans. Because derivative contracts are so abstract (they can even be based on other derivatives), it can be challenging for traders to understand their exposure. This was certainly the case in the years leading up to 2008, where derivative contracts based on risky mortgages collapsed.
That collapse kicked off a wave of regulation that is only now culminating in the (delayed) enforcement of Uncleared Derivatives Variation Margin regulations. Not only will traders now need to post/transfer VM collateral, but they need to institute advanced reporting and intelligence programs to understand their positions and exposure.
If a set of assets are facing a downgrade, or if a currency is fluctuating, Collateral Management teams need to know and adjust their portfolios accordingly to manage risk and exposure while staying within the predetermined Concentration Limits. And despite the CFTC’s “no-action” letter granting a six month reprieve for Dealers to get up to speed:
“Market users would still have to document the steps taken towards full compliance and put in place alternative arrangements to ensure that risk of non-compliance is contained.”
In short, this means that firms will need to ensure they are able to report the progress they have made in repapering their trading Relationship Agreements (including ISDA MAs) and all of their Credit Support documentation (including ISDA VM and IM CSAs).
Firms must also conform to new operational processes, such as implementing sophisticated calculation methodologies and adhering to far shorter settlement periods. Where parties used to settle transactions over 3-4 days they now only have 1 trading day, making information access and reporting all the more critical.
Why is the margin rule so important?
In the past, most credit-worthy trading institutions had reduced obligations to post collateral. That privilege was reserved for the Dealers, aggressive risk-takers and smaller shops. Now, all trading institutions have to post collateral. And they want to post as little as possible since every asset used as collateral is an asset that cannot be used for profit, as well it increases the costs per trade.
For many banks, this regulation requires them to create new processes to manually review and map millions of contract data points. They need this data for several reasons including: (1) reporting, (2) short-term collateral optimization, and (3) long-term contract renegotiation.
To achieve these goals, they need to extract a higher level of insight from their unstructured data than ever before, even compared to review for litigation. In a discovery scenario, reviewers are looking at documents to determine delineated issues for relevancy and privilege. In the financial risk scenario, reviewers are looking at contracts to figure out what terms have been negotiated with their counterparties to manage and limit their risk from Jurisdictional Netting ability, applicable Covered Transactions and imposed currency haircuts to Transfer of Interest Payment commitments and other specified conditions.
The OpenText Fintech solution
Regular readers of this blog are well acquainted with OpenText Discovery’s “legaltech” but perhaps not as familiar with our “fintech” solution, Perceptiv. It’s built on the same underlying platform and technology as Axcelerate and, in particular, leverages the same award-winning processing engine.
Perceptiv processes hundreds of thousands of derivative contracts with preconfigured data models for the key Variation Margin CSA contracts and captures all the key terms according to client specifications (well over 200 fields per contract). Each field is then automatically mapped and organized for technology-assisted review and analysis in a workflow that is similar to traditional review for litigation. Exports of this data can be used internally at the various financial institutions to review risk for trading as well as implementing into their collateral systems for daily margin calls.
This blog was co-authored by Adam Kuhn.