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27th April 2022 | Insights

Rethinking margin management ahead of Phase 6 of UMR

In our last post on Phase 6 of the Uncleared Margin Rules, we considered the derivatives industry’s challenge in bringing the final round of firms into compliance with the regulation.

We focused on the type of firm coming into scope – much smaller than in previous rounds and mostly lacking the operational infrastructure needed to post initial margin effectively. The Acuiti report, Margin Management for Hedge Funds, which was commissioned by Cassini Systems, found considerable uncertainty among hedge funds as to whether they were coming under the rules.

As a result, many firms are unprepared for the costs of compliance and the significant changes to the way they handle margin that will emanate from UMR. The impact these firms have will spread beyond their own preparations for how they manage margin.

UMR will also change how firms coming into scope think about trading. Acuiti research shows many hedge funds operating under the rules have seen their performances impacted, with margin requirements creating a drag on returns.

So, while phase 6 of the roll out in September will be the final regulatory act of a 13-year long implementation, the long-term impact of margin on uncleared trades is only beginning.

The rules’ impact on large bilateral derivatives markets, such as that in FX could be deep, with participants used to bilateral trading having to overhaul their infrastructure and potentially consider new trading instruments to reduce margin requirements.

To reduce drag, margin requirements will increasingly be calculated across portfolios. In addition, against a backdrop of more complicated collateral suites and the elevated risk of big and sudden margin calls amid continued volatility, the ability to evaluate a trades’ margin impact pre-trade has never been more precious.

This will boost the importance of pre-trade analytics and portfolio margining tools that minimise UMR’s impact and even keep firms away from posting initial margin entirely – by virtue of remaining under the threshold for inclusion.

A variety of routes exist to reducing uncleared exposures. The most obvious first choice to consider will be cleared instruments – whether listed or cleared OTC – with exchanges and clearinghouses already offering a variety of listed alternatives to the uncleared markets.

Funds will have to balance margin costs with other factors such as liquidity, which is often still superior in bilateral markets – and of course, listed and cleared instruments come with their own margin requirements.

Another route firms can take is spreading their uncleared exposures across counterparties, trimming their positions to stay under the Average Aggregate Notional Amount (AANA) that regulators use as a threshold for compliance. This will require updated monitoring capacity and is not without risks.

Funds could run greater counterparty risk and even struggle to maintain the strategy if certain prime brokerages pull back from certain operations or offboard clients – a risk that was highlighted last year with the fallout from the Archegos blow-up.

The Acuiti report found that the most common reason for hedge funds reducing prime brokerage lines was their being offboarded by providers following strategic reviews. So, the risk is already very real.

Whatever path they chose, a more pro-active approach to the management of margin is essential for firms navigating UMR or increased clearing of their positions. Many firms are due to discover that not only does UMR compliance complicate trading desk calculations but so also will its avoidance.

To download the full report: Margin Management for Hedge Funds: An Increasingly Complex Calculation, click here