Market Insights

Making the Trade Possible: UMR and the Future of Collateral Management

The Uncleared Margin Rules (UMR) are prompting buy-side firms to
rethink their entire approach to collateral management.

February 2021

The UMR, which require firms to post and manage initial margin (IM) for non-centrally cleared derivatives, began for the largest organizations in 2016, followed by three more size-based tranches.

Amid the market disruption caused by the COVID-19 pandemic, the consortium of global regulatory bodies governing UMR extended the deadlines by one year for the last two phases. Phase 5, covering entities with more than US$50 billion in average aggregate notional amount (AANA), now takes effect in September 2021. The final Phase 6, for firms with at least US$8 billion in AANA, comes into force in September 2022.

Institutions in scope for these rules must have strong counterparty relationships plus a range of sophisticated operational and analytical capabilities to assess their exposure and ensure compliance. According to Staffan Ahlner, our  global head of Collateral+, UMR signifies both challenges and opportunities for the buy side. Here, he discusses with our head of EMEA Insights James Redgrave the implications of UMR, as well as how investment institutions can best organize their wider collateral management strategies.

JR. What have been the main developments driving change in collateral management up to now?

SA. Collateral management initially grew out of the broker-dealer market. This meant it was built around the needs of the sell-side firms, which had to be able to raise capital. We’re seeing a big shift now with UMR, in that variants of the same tools are being deployed specifically for the buy side. Collateral management is no longer optional for these firms — it’s mandatory to comply with regulation. Industry participants must be proactive in creating smooth, frictionless workflows to govern their collateral.

UMR is one part of the wider collateral ecosystem. Collateral is becoming more and more common in various transactions. The ability to transform collateral is crucial for some clients, as is ensuring continuous access to liquidity. We have seen this repeatedly in the market where collateral is the foundation for a well-functioning financial ecosystem during several credit and liquidity events. If you’re working on the buy side, you need to engage in liquidity, risk and compliance planning and make sure you can meet any changes in the markets or investor behaviors such as redemption, changes in risk appetite, or simply to raise or place cash in the market or transform your collateral. For sustainable operations, firms needs to ensure they have a collateral strategy and the ability to execute their strategy.

JR. Are there any lessons large firms can share as smaller ones begin to implement UMR?

SA. Phase 1 of UMR was tough for everybody. There was a lot of heavy lifting that had to be done to meet the requirements. Since then, in every way, the industry has become better at collateral management. But even today, we are finding trading arrangements that are challenging for the buy-side firms to fulfill all the standards that are out there. At State Street, we are committed to providing education to the industry and helping firms to understand what is needed.

JR. Are there different regional or national regulations that make a difference for investment institutions seeking to engage in collateral-based transactions?

SA. Yes, there are. Even within UMR, there are regional nuances in what’s included in the calculations. You have differences in certain markets regarding what can be taken as collateral. Beyond that, complexities can also exist by institution type or counterparty. For example, insurance companies often have certain restrictions around what collateral they can accept and how it is held. Different funds have different restrictions depending on type and regulations, each fund has an investment policy that governs the activity. Further regulation is set on a legal entity level and not fund level, a multi-fund management structure need to have an overall view of the activity for regulatory perspective but can still have a fund-level view on other aspects such as risk appetite and liquidity needs. So, collateral solutions are not one-size-fits-all. Collateral solutions must be fitted to the needs of particular organizations and their specific trading behaviors. Collateral can mean many things, so it’s important that its management of collateral is aligned to the particular collateral strategy that each asset owner and asset manager
is running.

JR. How do you see the industry evolving when it comes to collateral management?

SA. I do expect things to continue to change, and we will have to learn to do more with less. This will continue to be the expectation of the financial industry. Sell-side firms will have to do more with less capital. Buy-side firms will need to ensure they have sufficient liquidity without relying on excessive cash in the portfolio while ensuring they meet their investment strategies. A centralized, holistic approach will be key to all of this, which translates into a higher degree of technology and automation.

JR. We’ve talked about some challenges presented by this regulation. Are there also opportunities from these rules to promote efficiencies and improvements in institutions’ operations, around things like risk and financial management?

SA. Absolutely. Collateral makes the trade possible in the darkest times. We have seen institutions execute major transactions with a counterparty where the counterpart has become insolvent, without financial losses. This wouldn’t be possible without collateral. From that perspective, in its simplest form, collateral is a highly effective way to mitigate counterparty risk. And as an industry, we are constantly looking for innovation — ways to improve and ways to deploy new technologies to increase efficiency — so there is clearly an opportunity there.

JR. What distinguishes the institutions, as well as their third-party solutions providers, that are doing the best jobs of meeting these obligations, in terms of their approach and the systems and processes they’ve put in place for collateral management?

SA. To arrive at a fully integrated solution across the value chain depends on the structure of the organization. Are they going to run collateral teams in house? Or are they going to use external agencies to run that on their behalf and do the lifting on the operational side? This would dictate the specific parameters of the strategy. But, either way, the most successful firms tend to be very good at managing data. They know what their exposures are at any time and have good grip on the relevant data.

Leading firms take a holistic view instead of just considering individual pieces, choose a partner that can service not only today’s needs but also the upcoming needs, a partner that grows and adapts to upcoming trends. This means that firms are not only solving for the UMR, liquidity or capital risk. Instead, they centralize their financial and collateral resources, organizing their data, setting up their organization to be flexible for future needs. We have seen increasing centralization of treasury management activities across the industry to mobilize collateral and execute on well-thought-out collateral strategies.

Finally, connectivity to the market ecosystem is essential. Having a collateral manager with the right linkages to trading and liquidity venues is very important to give you options now and in the future. You may initially select a partner for UMR, but beyond that, you also need a partner who can service other trades, can manage collateral transformation, can help you reach out to the market and to the relevant trading venues either direct or through sponsored access, to get the reconciliation feeds and the necessary data. So again, taking a holistic view in your collateral partner selection will put you in a strong position to have those capabilities and connectivity.