Author’s note: Check out the sidebars for more detailed definitions of specific acronyms and resources that may not be familiar, as well as key dates. The International Swaps and Derivatives Association (ISDA) website is also a great reference that can provide clarity and additional information around UMR.
Undoubtedly, the uncleared margin rules (UMR) have been, and will continue to be, a hot topic in the derivative industry. They directly impact derivative market players, including insurance companies. If you haven’t paid attention to these rules up until now, you’re already a little behind. But don’t worry—this article will catch you up on the process, scope, key dates and how to prepare.
Margin can mean different things in different contexts. Actuaries typically are familiar with margin for uncertainties when it comes to developing actuarial assumptions or profit margin as a financial ratio. But don’t get confused—margin in this context represents a type of collateral required when trading a derivative contract.
UMR Definitions and Resources
Average aggregate notional amount (AANA)
Measured annually to determine the potential Reg IM phase-in dates and whether the market participant will continue to be subject to UMR post-compliance. Note there may be differences in the AANA derivative scope and calculation method depending on the regulatory regime.
Basel Committee on Banking Supervision (BCBS)
An international committee formed to develop standards for banking regulation.
A derivative contract that is booked with a clearinghouse and is listed on a regulated exchange. The clearinghouse assumes the role of derivative counterparty to the trade and imposes mandatory margin requirements. The major advantages that cleared derivatives have (over OTC derivatives) are standardization and elimination of default risk.
Initial Margin (IM)
A type of collateral required to protect a party to a derivative contract in the event of default by the other counterparty. IM is posted when the trade is executed and then adjusted as necessary throughout the life of the trade. For centrally cleared derivatives, counterparties post IM to the clearinghouse. For OTC derivatives, counterparties post IM to each other.
International Organization of Securities Commissions (IOSCO)
A global cooperative of securities regulatory agencies that aims to establish and maintain worldwide standards for efficient, orderly and fair markets.
International Swaps and Derivatives Association (ISDA)
A trade organization of participants in the market for OTC derivatives.
The model that ISDA developed determines the Reg IM requirements based on a 99 percent confidence level of cover over a 10-day standard margin period of risk. As of December 2020, it is the only regulator-approved risk-based model market participants can use.
OTC Derivative (or Uncleared Derivative)
A derivative contract that is negotiated bilaterally (privately) between two parties without going through a formal exchange or other type of formal intermediaries. Therefore, OTC derivatives can be customized to suit the exact risk and return needed by each party. Although OTC derivatives offer flexibility, they pose credit risk because there is no clearing corporation.
If this is the first time you are hearing about it, you may wonder, ummm, errr, where does this UMR—also known as the initial margin regulatory requirements (Reg IM)—come from? UMR is a reform of the initial margin (IM) processes being driven by the Basel Committee on Banking Supervision (BCBS) and the International Organization of Securities Commissions (IOSCO).
IM is a standard concept in the derivatives market. Even before the financial crisis of 2008–2009, it was not uncommon for the over-the-counter (OTC) derivatives to require some form of IM. However, the exchange of IM between trading counterparties typically depended on bilateral agreements and varied on a case-by-case basis. For instance, counterparties may not need to post IM at all per the bilateral agreement, or there may not be any restrictions on the collateral types that counterparties can post.
The financial crisis was a wake-up call for global regulators to improve transparency in the OTC derivative markets and standardize the margin requirements for noncentrally cleared derivatives. As a result, major financial regulators around the world have adopted the final framework established by the BCBS and IOSCO for each relevant regulatory regime. Although there are some jurisdictional differences, the general approach the regulators took to implement the new Reg IM rules is consistent, with phased-in compliance dates from September 2016 to 2022.
But why does all of this matter to you, as an actuary? Many insurance companies, especially life insurers that carry various annuity and insurance products with embedded optionality, use a variety of OTC derivatives for hedging different types of risks. UMR may pose additional margin costs and liquidity challenges for these insurers. Additionally, new custodial relationships may need to be built because UMR requires counterparties to post collateral to a segregated custodian.
Thus, actuaries should understand the implications of UMR for different business models to help their organizations better position themselves under the new regulation. For example, derivatives portfolio optimization and risk transfer using reinsurance are good solutions to minimize the margin burden for some companies. (Keep in mind that applicability to a specific organization depends on criteria such as the amount of derivatives exposure, types of derivative instruments and the counterparty’s domicile—rather than the hedging techniques, per se.) Meanwhile, UMR also may influence insurers’ pricing strategies on products that provide long-term guaranteed payments, incentivizing them to exit from any existing products that are too costly to hedge or reveal opportunities for developing new products that would shift some risks to customers.
Under the U.S. UMR, any swaps that are not centrally cleared, including security-based swaps, cross currency swaps and physically settled FX swaps and forwards, are in scope when determining the average aggregate notional amount (AANA) and calculating Reg IM amounts post-compliance.
It’s worth noting that, although regulators in different jurisdictions treat UMR similarly, there are some differences based on the regulatory regimes. For example, derivative scope, as well as how AANA is determined, differ between the U.S. and European Union (EU) rules.
Key UMR Dates
UMR compliance is a phased-in approach. Most insurance companies with relatively large uncleared derivatives positions, like many other buy-side firms, are expected to be in scope for phases 5 and 6, which will occur September 2021 or later.
Currently there are six phases with decreasing notional thresholds for determining the adherence to UMR. In 2020, market regulators postponed the last two phases (5 and 6) by another year due to the COVID-19 pandemic. Here is the updated compliance schedule (under the U.S. rules):
- Phase 1. Sept. 1, 2016, if AANA of the covered OTC derivatives exceeds US$3 trillion.
- Phase 2. Sept. 1, 2017, if AANA of the covered OTC derivatives exceeds US$2.25 trillion.
- Phase 3. Sept. 1, 2018, if AANA of the covered OTC derivatives exceeds US$1.5 trillion.
- Phase 4. Sept. 1, 2019, if AANA of the covered OTC derivatives exceeds US$750 billion.
- Phase 5. Sept. 1, 2021, if AANA of the covered OTC derivatives exceeds US$50 billion.
- Phase 6. Sept. 1, 2022, if AANA of the covered OTC derivatives exceeds US$8 billion.
- Not applicable. If AANA is less than US$8 billion.
As of December 2020, companies trading uncleared derivatives with notional amounts greater than US$750 billion have been covered by UMR. The initial phases affected the interdealer industry and included mostly the sell-side companies and other big players in the derivatives market.
One example of this is that the U.S. and EU rules treat uncleared equity options differently. Uncleared options on securities or broader-based indices are not included in an U.S. AANA calculation, but they are included when calculating an EU AANA—although there is a temporary exemption for the OTC equity options in the Reg IM requirements under the EU rule. Another example is that the U.S. AANA is measured as the average daily notional of the covered OTC derivatives, while the EU AANA is measured as the average month-end notional amount of the covered OTC derivatives.
Reg IM Calculation
Reg IM must be calculated by one of two methods:
- A regulator-approved risk-based model
- A notional-based lookup table embedded in the new rule
For the first method, there is only one model currently available, which is the Standard Initial Margin Model (SIMM) developed by the International Swaps and Derivatives Association (ISDA). Each method has its pros and cons, so each market participant should perform a cost-benefit analysis internally to decide which to use. Currently, the SIMM has been widely adopted by the firms that are already subject to UMR.
There is a laundry list of activities to which in-scope market participants must adhere to get ready for the new rules. Because it can be operationally burdensome for market participants to prepare, a number of firms have outsourced certain duties of UMR to external vendors. For example, there are licensed SIMM service providers that can help with the daily IM calculations. Refer to the ISDA website for a full list of the licensed vendors.
Other activities for pre- and post-compliance include:
- Assess which jurisdictional rules will apply and which derivatives are in scope, depending on the regulatory regime.
- Determine if AANA exceeds thresholds and disclose to the trading counterparties in advance.
- Establish infrastructure for IM calculation and determine vendor strategy if necessary.
- Renegotiate and execute regulatory-compliant document (e.g., bilateral derivative agreements, account control agreements, eligible collateral schedules, etc.).
- Build custodial relationships, pledge IM to a segregated custodian and ensure no rehypothecation of collateral.
- Manage margin requirements daily.
If your company relies on OTC derivatives, it could be affected by UMR in the last two phases. The information in this article is a good starting point to form a game plan to face the challenges the new rules pose.
The information provided in this article is intended for educational purposes only and does not replace independent professional judgment.
Copyright © 2020 by the Society of Actuaries, Schaumburg, Illinois.