Hedge fund giants lead fourth wave of IM candidates

As many as 20 buy-side firms could become subject to the derivatives market’s new margining regime next year, in the next phase of its roll-out. Five of the largest hedge funds – BlueCrest Capital Management, Capula Investment Management, Citadel, Millennium Capital Partners and Rokos Capital Management – are expected to be among them.

The five hedge funds – each of which was named by at least two industry sources – are expected to be joined by some large asset managers, such as BlackRock, UBS Asset Management and Vanguard. Derivatives users will become subject to the regime from September next year, if the notional value of their non-cleared derivatives portfolio exceeds $750 billion.

“The vast majority in phase four are the smaller dealers but there are likely to be quite a few hedge funds and certainly some of the big asset managers. The trend is clear: we’re coming to a point where in-scope entities have less experience of providing collateral so it’s going to be more difficult to get them set up,” says a collateral manager at one US bank.

Dealers already subject to the rules are poring through client lists to work out which ones are likely to be caught, and get a head start on the time-consuming job of negotiating and signing the new documents required by the rules. Industry estimates suggest the total number of firms caught in phase four could be as high as 80, roughly double the number of entities brought in scope to date.

Citadel and Millennium declined to comment. BlueCrest, Capula and Rokos did not respond to requests for comment. UBS and Vanguard did not respond in time for publication.

Tony Ashraf, director of clearing and collateral management at BlackRock, said during a Risk.net webinar in August that the firm was expecting to be caught in next year’s roll-out.

Documentation crunch

Initial margin requirements on bilateral swaps exposures, part of post-crisis rules intended to make the non-cleared derivatives market safer, are being introduced in five phases from 2016 out to 2020. They require firms to collect initial margin from other in-scope entities if they exceed a notional threshold that drops each year.

In September 2018, Risk.net reported that Brevan Howard had become the first buy-side firm brought into scope as its non-cleared derivatives notional exceeded the $1.5 trillion hurdle required for phase-three compliance. Earlier this month, Brevan Howard confirmed it had joined a service run by AcadiaSoft that calculates and reconciles regulatory margin between derivatives trading counterparties.

The precise number of firms caught in the fourth wave will not be confirmed until three months before the September compliance deadline. This is because the $750 billion threshold, or local currency equivalents in non-US jurisdictions, is applied to the aggregate average notional amount (AANA) of non-cleared derivatives held by a firm, as measured over the preceding three-month period from March to May.

The vast majority in phase four are the smaller dealers but there are likely to be quite a few hedge funds and certainly some of the big asset managers

Collateral manager at a US bank

In-scope firms must negotiate credit support annexes (CSAs) and set up segregated collateral accounts with custodians – a bottleneck for phase-one firms in September 2016 that ultimately required regulatory forbearance.

Some buy-side firms have been preparing for more than a year. BlackRock, the world’s largest asset manager with $6.3 trillion under management, has been monitoring the notional amount of its non-cleared derivatives on a monthly basis since 2017, when all financial counterparties were required to start exchanging variation margin on the same population of trades. The firm also began work earlier this year to negotiate CSAs with its counterparties.

“One of the key things we’re trying to do is avoid the crunch we experienced with implementation of VM [variation margin] rules and really try and get ahead of this,” said Ashraf during the Risk.net webinar. 

He added that the firm’s non-cleared notional outstanding changes on a regular basis as more bilateral swaps exposures move into clearing.

Document negotiation platforms are currently being developed to ease the burden, but as a work in progress they may not be useful for phase-four compliance. Margin Xchange, a joint venture between Allen & Overy, IHS Markit and SmartDX, is going head-to-head with Isda Create, a joint venture between the International Swaps and Derivatives Association and Linklaters. AcadiaSoft’s AgreementManager, slated for launch in 2019, is intended to provide interoperability between those two platforms, while also offering standard document creation.

“Banks probably aren’t going to make decisions on whether to sign up for those platforms until mid- or early next year. For phase four, we could get by without the tools and will probably have to. It could get done manually, but if we have 1,000 counterparties come into scope, the tools become a necessity,” says a collateral manager at another US dealer.

As the rules stand, the AANA threshold plummets to $8 billion in September 2020, bringing into scope as many as 1,000 firms in the final phase – the so-called IM big bang.

Industry lobbyists have written to global regulators requesting a twelvefold hike in the phase-five threshold to $100 billion. The industry also argues foreign exchange forwards should be removed from the calculation – the contracts are not subject to margining requirements, but do count towards the threshold.

If regulators make those changes, the result would be a reduction in the number of phase-five counterparties from more than 1,000 to fewer than 100, according to Isda’s calculations.

The scale of a firm’s bilateral derivatives exposures is not always clear from public numbers. Even though they are expected to top the $750 billion AANA phase-four threshold, Citadel has $31 billion of assets under management while Millennium manages $35.5 billion.

But gross notional exposure of derivatives typically far exceed their fair value given the offsetting nature of positions. According to data from the Bank for International Settlements, the gross market value of over-the-counter derivatives outstanding in the first half of 2018 stood at $10 trillion. But the gross notional outstanding was almost 60 times higher at $595 trillion.

With Brevan Howard there was little indication of a $1.5 trillion-plus derivatives mountain. The firm’s flagship Master Fund had $17.7 billion in total assets at the end of 2017, including derivatives with a fair value of just $2.4 billion.