UMR Phase 5: A Real Challenge for Real Money?

September 1 was the “go live” date for phase 5 of the Uncleared Margin Rules (UMR), bringing firms with an aggregated average notional amount (AANA) of €/$50 billion into the UMR fold. Yet, instead of being a finish line that the market can move on from, this “go live” may be the start of larger challenges for the market.

Although phases 1 through 4 (which began in September of 2016) impacted the largest dealers first and then the largest hedge funds, phases 5 and 6 have often been seen as the most significant due to the sheer number of funds and institutional investors potentially caught by the AANA calculation, with the threshold falling to €/$8 billion in September 2022.

Whilst the broader strategic impacts of UMR on “front-end” trading behaviors are currently not totally clear, we have already seen some trends within clearing for foreign exchange (FX) which may in part be driven by UMR pressures. An increasing number of customers are embracing listed FX futures and options (the number of large open interest positions held by customers in CME FX futures is up 14% year on year¹), gaining diversified liquidity and capital efficiencies in the process.

Once caught by UMR, there are several actions each entity will need to take. These include the following:

• One-off/tactical items: New Credit Support Annex (CSA) with each bilateral counterpart, setting up a custodial account for the two-way posting of initial margin (IM), and implementing the ISDA SIMM model to enable IM calculation.
• Ongoing tasks requiring resourcing: Daily calculation, reconciliation, and dispute resolution of IM requirements. Funding, posting, and optimizing any IM over and above the minimum transfer amount (MTA).

Under UMR, the IM requirement for impacted entities exempts products such as deliverable forwards and FX swaps ‒ which leaves a focus on uncleared rates products (swaps and swaptions), equity swaps, non-deliverable forwards (NDFs), and FX options. Of all these, FX options stand out as a potential source of higher IM requirements – both because of how ISDA SIMM works and because the products most used for a delta hedge (forwards and spot) are excluded from the regulatory requirement.

Initial margin impact analysis on FX options provided by OpenGamma²

Phase 5, which industry participants estimate to impact between 150 and 500 entities, is likely to impact a large number of real money accounts ‒ the asset managers and pension funds who typically run large, directional books but who have never posted any IM and typically have never used (nor wanted to use) a prime broker (PB), given the inherent concentration on one bilateral counterparty.

Partly as a result of UMR pressures, we have seen an increase of 33.8% from end user customers in our listed FX options³, which provide margin and capital efficiencies through the netting of all positions against a highly regulated CCP and the ability to easily include delta hedges, as well as model differences for the IM calculation.

On the other side of the equation, hedge funds are arguably well positioned to help manage and optimize the ongoing impacts of UMR. They are well accustomed to posting an independent amount (IA) or IM on their positions and typically use a PB ‒ who can not only net all of their positions together but who may also be able to utilize IM models that enable margin optimization techniques such as consolidating FX forwards back alongside FX options.

Of all the market participants, real money accounts may face the greatest obstacles in dealing with the impacts of UMR over the coming months. A combination of a lack of familiarity in managing and posting IM, the counterparty credit concerns with consolidating risk with one bilateral counterparty as a PB, and the typically directional nature of trading could all result in increased costs and a need to adapt trading behaviors.

These potential challenges may help explain the recent uptick⁴ we have seen in use of listed FX options and emerging market (NDF) FX futures as cleared alternatives that are exempt from UMR – not only removing the human capital cost of the daily processes but also optimizing the funding cost of IM by having everything netted against a highly regulated CCP.

To discuss any of the themes explored in this article, please contact fxteam@cmegroup.com

1. CFTC large open interest holders data as of September 7, 2021.
2. Analysis performed by OpenGamma as of September 2021. The portfolios of standalone FX Options used were:
   • A long call butterfly spread in EUR/USD
   • An offsetting position in EUR/USD versus USD/CHF
   • A portfolio consisting of an assortment of trades in seven currency pairs (EUR/USD, USD/CHF, USD/JPY, AUD/USD, GBP/USD, USD/CAD, NZD/USD), with the OTC portfolio split across three different counterparts. It can be seen that the cleared margin can be significantly lower than the bilateral margin. According to OpenGamma, this is mainly due to:
     • The difference in the holding period assumed when setting the margin parameters (10 days for SIMM)
     • The offsets allowed within the SPAN algorithm - the intercommodity offsets between the different currency pairs in these examples reduces the margin by 20-30%
     • The netting benefits realized by moving from multiple bilateral counterparts to one central counterparty (the clearing house)
3. Data from CME Group. Year-to-date average daily volume in CME FX options as of end of August 2021 compared to same period for 2020.
4. As an example of this trend, we have seen all-time open interest records in AUD/USD and CAD/USD listed FX options during August 2021, as well as an all-time record for the number of large open interest positions held by customers in our Emerging Market FX futures on June 15, 2021.