Initial Margin: 10 key steps for a smooth regulatory compliance process

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22 FEBRUARY 2019

With the threshold level for compliance and initial margin regulatory requirements set to fall to $750bn from September, JDX considers the legal, operational and systems challenges facing financial institutions.

The International Swaps and Derivatives Association (ISDA) notes that final determination on whether an entity will fall under the initial margin regulatory requirements this year can only be made after the aggregate month-end average notional amount observation window (typically between March and May for a September implementation). However, it also observes that firms will need to conduct estimates before the observation window in order to have enough time to prepare.

Those institutions that fall under the scope of the regulations will not only experience a significant additional burden on legal departments to negotiate and execute large volumes of complex contracts – they will also require substantial change from an operations and systems perspective. In order to help banks understand the processes required to ensure smooth progress towards compliance, we have outlined below the steps that should be taken.

Step 1:  In-Scope Entities
The first action required is to identify in-scope entities for Phase 4 (which takes effect in September 2019) and Phase 5, the final phase under which the threshold falls to $8bn from September 2020. ISDA has produced a self-disclosure letter to help banks standardise the process, but they may still require a client outreach component to validate which entities are in scope for which phase.

Step 2:  Documentation
Banks should check current documentation and any amendments. Organisations that have been through large contract digitisation efforts may benefit from having documents ordered and data already extracted.

Step 3:  Initial Compliance Discussion
The next step is the initial compliance discussion, which involves discussing with counterparties which custodian the bank will use to post initial margin and the model it plans to use to calculate initial margin. Issues to address here include thresholds, minimum transfer amounts, eligible collateral and haircuts.

Step 4: KYC Checks
It is worth ensuring adequate time is allocated to custodian onboarding and KYC checks due to the increased volume of KYC that custodians will be required to perform.

Step 5:  Data and Playbook Readiness
There should be a process in place for collation of data from across the organisation prior to creation of a termsheet or negotiation, (which will need to include key entity and economic details) as well as the creation and editing of a playbook. Adequate playbooks should be in place and have necessary approvals around parameters for negotiation.

Step 6:  Means of Repapering
Organisations should then consider their technology and resource plan for tackling the increased volumes associated with Phase 4 and 5 of the initial margin regulatory requirements. When deciding on whether to use a technology solution and which solution to select, the following factors should be considered:

  • Can determination and compliance work be tackled manually?
  • Does using a contract generation solution fit within the strategic plan around linking documents to data and a straight through process?
  • Does the data model with the templates align to downstream systems?
  • Does the time saving generated by the solution reduce the overall cost of the programme?
  • Is the solution interoperable with other document generation technologies?
  • Have clients indicated a preference for the method of negotiation or software they intend to use?
  • What does the associated up-skilling time look like?
  • Does the product support only initial margin documentation or can it be used to support other document types?
  • Does the vendor software have current APIs with either entity information providers, contact information or downstream collateral systems?

Step 7:  System Training and Customisation
Banks that have purchased vendor software need to ensure adequate time is factored into training to ensure users understand how to use the system and its functionality. It is also important to check whether the templates within the tool require language customisation and if templates need to be created for different buckets of client types to expedite the process in the future.

Step 8:  Repapering and Negotiation
The next step is to ensure adequate resourcing and skill levels are in place for repapering and negotiation and that a process has been established (and resources allocated) for dealing with any exceptions.

With potentially multiple vendor solutions assisting with repapering, the reporting challenge could become more complex. Banks need to consider whether reporting can be done centrally or if the status reports need be pulled from a variety of systems/spreadsheets.

Step 9:  QA and APIs
Before execution, it is vital to have a QA layer in place to ensure contracts which differ from permitted language or positions have not been executed.

In terms of APIs, it is necessary to check if they have been created from contract generation systems to downstream systems, internally or to external systems.

Step 10: Contract Storage

Where will the final, executed contracts be stored? Between vendor solutions and banks’ internal systems, consideration should be given to where is the most effective place to store the contracts. This consideration should not only be from a storage perspective, but also which location creates the most effective link between the document and the data contained within it.

In conclusion, initial margin regulation - though large in volume and complex in nature - presents an opportunity for the industry to improve the link between data and newly negotiated and executed documents. Due to resulting progress in the quality of contract generation technology solutions, the way in which contracts are negotiated and executed may change forever. Whilst that may require large scale change, it is also a real opportunity to improve processes, provide detailed audit of end-to-end contract negotiation, eliminate risks of bad data quality as a result of manual keying of information from contracts into systems and improve reporting.

It is also an opportunity to create strategic links between documents and downstream collateral systems, which will improve processes and data quality in the future.

To this end, organisations should carefully consider whether available solutions fit within their strategic vision and the extent to which up-front investment can produce long term savings.