Margin reform tsunami and the tidal wave of documents
September 2016 | EXPERT BRIEFING | FINANCE & INVESTMENT
At the time of writing, as the first deadline of September 2016 is imminent for the first wave of compliance to the new BCBS IOSCO requirements, organisations are still wrestling with the full implications of the biggest overhaul in OTC derivatives trading in two decades. Despite the fact that the new regulatory environment will provoke a fundamental change in the way margin is managed, the underpinning documentation and data details are still to be set in stone.
As institutions start to invest in the massive manual effort required to create the hundreds, even thousands of new documents required, the implications of regulators’ failure to address the data needs up front are beginning to bite. From the inability to systemise compliance to the likelihood of disputes arising between institutions on collateral terms and the long tail of amendments that will be required before a state of satisfactory legal and operational risk is attained, this reactive approach to regulation is inadequate and ill-judged.
Why has this journey to implement the margin requirements for non-centrally cleared derivatives been so drawn out and tortuous? The new BCBS IOSCO regulations are designed explicitly to reduce risk and promote central clearing – yet at every stage the process of defining and agreeing requirements has only undermined institutions’ ability to comply. From the iterative rule-making process, a failure to provide final regulatory rules with enough time to then react, jurisdictional rules that are hard (if not impossible) to reconcile across a truly global market, the unacceptable squabbling over document requirements, to a failure to consider the data and systems implications up front, the reality is that despite the passing of the first deadline, key aspects are still unclear.
This was meant to be all so different. In 2011, after the G20 agreed to add margin requirements on non-centrally derivatives to the post-crisis reform programme, they called upon the BCBS and IOSCO to develop consistent global standards for these margin requirements. It was to this end that the Working Group on Margining Requirements (WGMR) was formed in October 2011, releasing its initial consultation in July 2012, followed by a second in February 2013. The aim of setting global minimum standards for this margin reform was noble, but the execution as this has then been handed over to regulators, dealers and the broader industry has sadly been, at best, poor, as evidenced by the deferral of the first September 2016 deadline in Europe to 2017; a scenario which adds further complexity and the risk of creating an un-level playing field as the US and Japan appear to hold firm to this deadline.
Blame for time wasted by emphasising form over the substance of the resulting documentation can certainly be levelled at the dealer community. However, the regulators are far from faultless – they have completely failed to provide the basis on which certainty and order could be achieved. These regulations are being worked out iteratively in a way that fails to reflect the need for financial stability. The proposed margining requirements for uncleared derivatives is a fundamental change of a way of operating that has been in place for over two decades and that shift provokes consequences that should have been thought out far, far better.
The immediate implications of this are significant – compliance demands a tidal wave of new documents to support the new Initial Margin (IM) and Variable Margin (VM) requirements. While those entities exceeding a threshold of $3 trillion aggregate average notional amount of non-cleared derivatives are expected to generate around 400 new documents in order to be able to continue to trade, the rest of the market has to comply according to a phased-in approach from 2017 onwards, meaning that the figure could reach 10,000 documents for a large investment bank (and that’s ignoring the custody arrangements that will be needed).
Hands on deck
As a result, focus is now turning toward physically getting the documents in place – a massive manual process that demands a somewhat chaotic, ‘all hands on deck’ approach where anyone with even the most basic understanding of the ISDA documentation is going to be press-ganged into service. There has, of course, been a turn toward the saviour of an industry protocol – where one can reduce the documentation burden to a series of matched questionnaires instead of negotiating a full blown agreement. Yet it is hugely frustrating that this rush toward documentation ignores the key underpinning issue: what happens to the data contained within that documentation? The protocol is particularly guilty of this, converting the documentation burden into a far bigger data problem (assuming the counterparty agrees to use such a needlessly complex protocol document and process). If the goal is to reduce risk and make the industry far safer, institutions need a way to give effect to the data held within the document. Operationally, it is the ability to manage the collateral that is key to realising the objectives of the regulation – namely, financial stability. That occurs through the data representation of the collateral arrangements.
The sheer volume of data means that just creating documents is meaningless. If it can’t be represented as structured data, it is hard to do anything with it operationally. This was the moment for the industry to move to a data-driven paradigm of document generation and negotiation. As organisations begin to appreciate the data angle, however, timing is against them, and one can only negotiate these documents in the age-old inefficient manner.
From a legal standpoint, it does not matter whether one refers to the regulation sub-paragraphs or inserts them into the document text – the end effect is the same. In fact, even if one is silent, the regulation, mandatory in nature, still applies. So it is key that one worries about how to represent that regulatory data, less so where the wording will go – provided a decision, preferably consistent, across the industry, is made.
From a technical drafting perspective, it really does not matter whether one has one or three collateral arrangements with a counterparty – the former simply containing three separate sections, one for the existing mode of operation, one for IM and one for VM. However, a lack of standardisation of the contract representation has meant the luck of the draw as to whether the approach taken will break firm systems. Of course, firms will fight out their preferences over the coming months, because of this failure to begin with the legal data.
If the regulators had looked at the data first and then agreed the documentation, it would have been easier to define the data attributes up front to fit the contract. Instead, institutions are now operating in this uneasy world where neither the data nor the documentation has been adequately defined. Teething pains are inevitable – documents, data and systems will need to be improved post compliance and there will be a drawn out process of fixing all the imprecise or problematic documentation.
There is no simple solution to the problem that has been created by this defensive approach. Few firms will be operationally ready for compliance or ‘legal-data accurate’ from day one – the legacy legal data systems have not been designed with in-built flexibility to enable an agile build demanded by the manner in which the regulation has fallen.
Getting the linkage between related documents, protocols and their data fields in place will be an ongoing process to tailor to the requirements once the documents are signed. While many issues will necessarily be addressed through a feedback loop as things break, the reality is that there will be a long tail in terms of getting into a position of satisfactory legal and operational risk.
Frankly, the entire process has been mishandled. It would be great to be able to say: here are the data requirements for BCBS ISOCO compliance and here is the solution. Instead, organisations face a lot of hard graft both to achieve some degree of compliance in time and then to unpick the problems created by the lack of data clarity. Now there is no option but to take short term tactical decisions and then address problems later in a more strategic manner. We can only hope that lessons learnt during this process will ensure that ongoing regulatory change will take more of a data first approach in the future.
Akber Datoo is the founder and managing partner of D2 Legal Technology. He can be contacted on +44 (0)20 3070 2266 or by email: email@example.com.
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