FX Market Approaching Last UMR Test: Is Change Upon Us?

When phase 6 of the uncleared margin rules (UMR) came into force at the start of September 2022, there was no ‘big bang’, in spite of some warnings to the contrary – now however, the first real test of firms now in scope of the regulation is fast approaching, with the end of the AANA (aggregate average notional amount) measurement window on May 31.

Although most market participants will have a good idea whether or not they are above the $8 billion (or equivalent) threshold for AANA, there are many asset managers who may be on the cusp, who simply could not state firmly whether they would fall within, or without scope – that question will be answered next week.

Equally, some managers who understand they are subject to the rules, will not have systems and processes in place to cope with what will be a significant change to their business. Thus far, the banking world has come into cope, and largely coped, the story may be different with the asset management industry.

“Running AANA calculations is a complex process with the exact requirements dependent on the jurisdiction of the firm and their counterparties,” says Jo Burnham, risk and margining SNE at derivatives analytics firm OpenGamma. “Differences exist for the calculation period, the methodology and the products in question.

“Some firms may have found it harder than they expected to calculate AANA during this current window,” she continues. “Firms need to decide whether a fund should be classed as an independent entity, and for multi-manager funds there can be issues with consolidating the calculations.

“On the assumption that firms have managed to complete this current period of their AANA calculations, unless firms are looking to change their trading strategies over the next few months, they should have enough information to know whether they are likely to be in scope or not,” Burnham adds.

In Scope Challenges

The final phase of UMR was thought likely to impact over 1,000 firms currently trading foreign exchange, bringing their use of, for example, OTC FX swaps and options into use. This could be seen as representing a much-needed boost for FX clearing, although it is unlikely to be an open door for providers due to the costs involved. One asset manager spoken to said their firm “is likely in scope” but has been activity engaging with counterparties to utilise netting, novation and compression services. It has also focused its trading in these products to offset existing exposures with a counterparty where available.

The quantum of margin posted for both cleared and non-cleared portfolios is at historical highs, and even the smallest movements in any one of the multiple exogenous factors that come into play can have a significant impact to the overall ‘cost’ of collateralising exposures.

The manager observes still, however, that UMR is an “unwelcome” additional burden on its operations staff, not least because of the calculation process itself. This is a point made by Neil Murphy, business manager at Osttra’s TriResolve, who explains, “If firms find out they are in scope after calculating AANA by this time next week, how to calculate initial margin will need to be front of mind. Whether firms expect to post IM or monitor IM, they need a reliable way of performing the calculation to provide transparency into how close they are to internal thresholds.

“In addition, once these firms begin exchanging IM, their systems will need to withstand reconciliation disputes,” he warns.

This is a point made by a collateral exert at a US bank, who observes, “Those firms that have been engaged with UMR from the start, mainly the large banks, have a process in place for margin disputes, nothing it prepared for the same problem with small managers. These firms don’t have the resources to build the appropriate functions with the right technology, therefore we are expecting to have a rough few months with some of our clients as we work through the issue.

“Ultimately, it may have to be a matter of trust for some firms that the data they are presented with by their banks is accurate.”

For some, the end of May will be a catalyst for action. “We are waiting to see what our number is and what it means for the business,” explains the asset manager. “We expect to have to move quickly once we know, however, and that will be a challenge. One avenue we will explore will be listed, cleared, products, but we want to avoid that if possible, because of liquidity and tenor issues for some of our funds.”

We are not seeing too much in the way of customers asking to trade in listed products, or indeed for trades to be cleared, but when they are faced with the final reality of what it will cost, they may have to make some tough decisions and change the way they trade

There is little doubt that clearing will receive a boost from the AANA calculations, even if it is via a compression or novation service. Equally, smarter allocation of credit can play a role, as pointed out by Andy Coyne from CobaltFX in a recent interview with The Full FX. Ultimately, however, there are many in the FX industry who expect asset managers to adjust how they trade and to embrace the listed space. “I would watch, for example, CME’s FX numbers, for signs of a shift,” observes a senior banker in London. “We are not seeing too much in the way of customers asking to trade in listed products, or indeed for trades to be cleared, but when they are faced with the final reality of what it will cost, they may have to make some tough decisions and change the way they trade.”

Trading in the listed markets, however is not a simple solution to the problem because, as noted, many firms require hedging to specific dates and prefer to execute their FX hedges in single, large notional trades. CME’s FX Link seeks to solve this issue to a large degree and it will be interesting to see what happens to its average daily volume as 2023 progresses. Thus far in 2023 the story has been mixed, with two very quiet months for the service in January and February, succeeded by better months in May and April. Overall though, FX Link’s ADV of $1.8 billion per day, remains lower than the $2.23 billion average throughout 2022.

Likewise, clearing can come with significant costs, a point made by Jerome Kemp, president of Baton Systems, who observes, “clearing more of your trades is not a simple exercise right now”.

Kemp continues, “The posting of margin and the optimisation of the mix between cash and non-cash collateral, and indeed accurately assessing the optimal hierarchy of eligible securities to post as margin, is complex. The quantum of margin posted for both cleared and non-cleared portfolios is at historical highs, and even the smallest movements in any one of the multiple exogenous factors that come into play can have a significant impact to the overall ‘cost’ of collateralising exposures.

“Various fees such as haircuts, concentration limit, and interest rates applied by CCPs and collateral agents, as well as the availability of eligible securities in market participants’ custodial portfolios, can change frequently and with little notice,” he adds. “Having real-time visibility to this data becomes a fundamental component to empowering a market participant’s ability to post, recall, and replace collateral as a means of ensuring that the most economically efficient margin posting is in place.”

As was the case with the implementation of phase 6 of UMR, the end of the first calculation window for many firms is unlikely to create much of a tremor on the market landscape. Further out, however, meaningful changes in how firms trade and operate could emerge, creating a challenge for service providers as they strive to keep up with yet another new set of client demands.

The answer, according to Baton’s Kemp, is all about technology, including distributed ledger technology. “Enhanced workflow, powered by real-time visibility of margin obligations, collateral posted and assets available for use, and CCP and collateral agent specific eligibility and fees structures, will be an essential feature of any operational strategy to optimise the margining process,” he says.