Uncleared margin rules are nearing their final stage

Diego Thomazini/iStock via Getty Images

By Paul Woolman

In short

  • Sixth and final phase of uncompensated margin rules arrives in September, with more than 700 investment management firms affected
  • As companies prepare to meet OTC derivatives margin requirements, listed equity indices and foreign exchange markets see increased activity

As of May 24, there are 100 days left before the start of Phase 6 of the Uncompensated Margin (UMR) rules, impacting more investment managers. This phase is arguably more significant than previous phases due to the non-cleared over-the-counter (OTC) asset threshold dropping to $8 billion from the previous threshold of $50 billion. This means that many more investment firms, including banks, hedge funds and asset managers, will be subject to these rules with around 775 customers complying with the rules compared to 319 before the effective date.

UMR transitory thresholds and counterparties

Sources: Monticello Consulting Group and Ascendant Strategy

With the various market challenges we’ve seen over the past two years through the pandemic, inflation concerns, expected rate normalization and the Ukraine-Russia conflict, it’s easy to see why attention may have be diverted from managing the impact of UMR and the capital efficiency challenges this can present. However, time is running out and clients will likely focus more on this topic as the September deadline draws ever closer.

What is UMR and how does it impact market players?

UMR is a set of rules that apply to margin (collateral) on uncleared OTC derivatives and was introduced by regulators following the 2008 financial crisis. Following the crisis, regulators wanted increase transparency, reduce systemic risk and increase market resilience, especially in times of stress. Over-the-counter derivatives, which were two-sided, opaque and often involved leverage, were seen as an area for improved oversight.

The uncompensated margin rules were phased in over time, initially affecting only the most exposed OTC clients. However, the notional OTC exposure threshold used to determine whether a client is affected by the UMR has been regularly lowered in phases. In September 2022, Phase 6 of the UMR will begin, meaning clients with calculated unmatched OTC exposure above $8 billion notional will be subject to the rules.

The amount of margin that should be displayed is often calculated using ISDA’s standard initial margin model known as SIMM and SIMM levels are adjusted over time.

What is the impact of UMR on capital efficiency?

Capital efficiency is a factor when evaluating the optimal instrument to deploy for a given investment strategy. Other factors such as liquidity, bid-ask spread, and commissions all go into the total cost equation. However, the impact of UMR is primarily on capital efficiency, and there are a variety of reasons why this matters. These include:

  • To avoid the decline in performance caused by not being fully invested in the market
  • Increase market exposure and free up capital
  • To optimize capital deployment

The above reasons are elaborated in a recently published article on capital efficiency and listed equity derivatives. The paper also highlights how we have seen capital efficient futures contracts gaining adoption by clients in the area of ​​equity index derivatives, dividend futures, Total Return Adjusted Interest Rate (AIR) futures and sector futures all increasing significantly in volume and open interest over the last 12-24 months. As of May 10, AIR futures are trading at around 5,000 contracts per day in 2022 (up more than 250% from 2021 average daily volume). Dividend futures were trading at 4,348 contracts per day in 2022 year-to-date (up 49% from 2021).

S&P 500 Annual Dividend Index Futures

Other asset classes such as FX are also seeing clients increasingly turning to the capital efficiency offered through listed solutions. One area is in FX options, where a recent paper identified up to 86% more capital efficiency for a given exposure via listed options instruments compared to bilateral OTC positions. The paper helps expand on this point and examines the growing use of listed forex options and emerging market futures (NDFs) by real money clients.

As of May 10, CME Group recorded a record large open position holders in FX futures of 1,312, which follows the historical level of open interest in FX futures and options of more than 3 million contracts (~$290 billion notional) earlier in the month. Asset manager adoption drove the growth spurt, with their positions up 60% since the end of the second quarter of 2020. Buyside accounts held the most open interest positions in EUR FX futures /USD cleared and quoted (60%), with hedge funds and brokers as well. holding significant positions at 15.4% and 24.1% respectively.

These growth trends for listed derivatives across all asset classes may well continue with the countdown to the UMR phase expiration in September. With hundreds more companies required to meet UMR requirements, this marks further market development to watch in 2022, even as all asset classes are impacted by macro events.

Original post

Editor’s note: The summary bullet points for this article were chosen by the Seeking Alpha editors.