Details of the Golden Gate Bridge

The Never-Ending Story of OTC Derivatives Regulation

The story of painting the Golden Gate Bridge has it that once you get to the end, you must start all over again. Similarly, adhering to global derivative regulation is seemingly a never-ending process. Here, we outline the significance of Initial Margin (IM) Wave 5 and what will follow it in the ever-evolving world of derivatives regulation.

Despite ten years of progress, global action taken in the financial derivatives market – which attempted to increase transparency and reduce risk – remains a work in progress. Derivatives trade reporting elements were implemented, primarily through EMIR and Dodd Frank requirements (among many other similar regimes in G20 countries), but the market continues to work through the sequential stages of the global central clearing and margin exchange regulations which were introduced on a multi-year phased basis.

The global initial margin rules have been implemented on a rolling five-year timetable that began in September 2016 with Wave 1 and have been coming into force in phases depending on thresholds of “Aggregate Average Notional Amount” (AANA) of non-cleared derivatives by trading parties through to 2020.

Wave 5 of IM draws in many smaller buy-side/asset management players who will in many cases – for the first time – have to pledge a significant amount of cash margin and collateral to cover the regulatory requirements. In addition, these entities will have to implement a specific framework to be compliant with the new rules, whereas the larger entities who entered into IM Wave 1 are now seasoned veterans.

Market analysis has determined that the final two phases of IM will encompass a large portion of the market with the buy-side asset management sector being particularly impacted by phase 5. 2020 may feel like a long lead-in time, but asset managers shouldn’t delay. For those who were intimately involved in structuring arrangements at the onset of the variation margin requirements, the mantra start planning early will ring true. The onboarding process for initial margin arrangements that meet the requisite regulatory requirements are far more involved.

Initial margin (IM) under EMIR is collateral to be collected by a counterparty to cover its current and potential future exposure in the interval between the last exchange of margin and the liquidation of positions or hedging of market risk following the default of the other counterparty.

Next steps

Given that the IM requirements introduce new concepts and obligations for asset managers, “Project IM” should commence immediately. These are just some of the actions that asset management firms should consider.

  • Identify the internal stakeholders – implementation will require coordination between legal, operations, collateral management, and custody teams at the very least.
  • Establish a clear understanding of the scope of existing derivatives documentation – it won’t be as simple as using pre-existing trading or margin documents, these will have to be regulatory compliant.
  • Set up or adapt custodian relationships specifically for the purposes of IM. Build in a timeline based on the reliance upon the cooperation of this third party.
  • Consider the availability of eligible collateral and how to manage the receipt of such collateral being mindful that the rules with respect to its treatment differs slightly in different jurisdictions. Determine regulatory compliant calculation methods.

Key EMIR IM obligations

  1. Identify calculation methodology: ISDA Standardized IM Model (SIMM) or other such as grid or table calculations
  2. Calculate IM within 1 business day of some events and 10 business days of other events
  3. Define haircut and concentration limits
  4. Calculate maximum threshold amounts for all OTC derivative contracts for all entities in firm’s group
  5. Create operational framework for collateral so manager can both post and receive collateral from OTC counterparts
  6. Segregate IM assets in accordance with the prevailing regulations
  7. Validate, back test, and audit chosen model
  8. Review all supporting documentation to OTC derivative trading for Wave 5 adherence

What will the new documentation structure look like?

Some derivative trading relationships require significant documentation changes in order to adhere to the IM Wave requirements. In some instances, there could be as many as up to seven additional agreements per counterparty or dealer relationship.

While compliance with the Variable Margin requirements were met with a single upgrade to an existing credit support annex, compliance with the IM requirements are far more complex and require additional documentation and legal agreements.


Given that firms need to self-identify whether the IM rules apply to their business and communicate this to their trade counterparties, the burden of commencing this process seems to sit with the buy side.  However well a dealer may claim to know its counterparty, the chances of being able to definitively assess the application and timing of the IM rules are low. Equally, the calculation that needs to take place to establish the AANA may only be determined post the observation window leaving a tight timeframe for being fully prepared to exchange initial margin by September of the same year. As a result, asset managers must verify quickly if they are on the cusp of a particular phase-in category (4 or 5).

Industry advocacy 

The scale of what lies ahead in IM phases 4 and 5 should not be underestimated and it has already been flagged as a concern by several global asset managers and industry associations. Like any sizeable regulatory implementation, the sheer volume of arrangements that newly in-scope firms will need to consider, establish, and negotiate, combined with the significant number of entities that come into scope in these two final phases will put market participants under weighty pressure to conclude necessary arrangements in a timely fashion. These challenges have been articulated within the industry, notably by the International Swaps and Derivatives Association (ISDA), who suggested a further regulatory review of the phase 5 threshold to align it with the risks associated with the trade activity. Whether this effort to delay or postpone the requirements or renegotiate lower threshold exemptions for small entities will succeed remains uncertain at this time.

The never-ending story

This tranche of the global derivative risk mitigation regulation may prove to be one of the most challenging yet. The impact will be far-reaching and impactful, changing the way in which the asset management firms use derivatives in their businesses.

While asset managers push to get through IM Wave 5, they shouldn’t forget EMIR 2.0, Securities Financial Transaction Regulation (SFTR), or LIBOR transition planning, because – just like the painters on top of the Golden Gate Bridge – the workload in the derivatives regulation space never really ends.