Mike: In this episode of our series on FX Rules Changes in 2023, we'll be looking at how SACCR and UMR are affecting trading and the solutions LSEG can provide clients. I'm Mike Cahill and our guide is Chris Leonard Appleton, head of FX risk and regulation at LSEG. We began our chat by asking Chris to explain what are SA-CCR and UMR and who they impact.
Mike: So, Chris, there were a lot of discussions recently about SA-CCR and UMR. The sound kind of exotic. Very briefly, what are these and who do they affect?
Chris: Well, hey, Mike, it's probably easy to start with what the abbreviations mean, and then we can sort of get into what they are. So SA-CCR is the standard approach to counterparty credit risk.
Chris: It's certainly gets the blood pumping that one. And then you UMR are the uncleared margin rules which have been implemented for uncleared trades and OTC derivatives. So it's worth noting that, you know. SA-CCR and that's how we refer to SA-CCR and UMR are the one small part of a very large package of prudential rule changes that have occurred since the financial crisis.
Chris: The intention of them have really been to make financial firms balance sheets far more stable and resilient, and also to ensure that OTC derivative trades that are uncleared are properly collateralized so that if there is a default then people aren't losing a lot of money. So I think you know, very briefly, SA-CCR, I mean it has been implemented really a phased approach to since mid 2021.
Chris: It's basically it promulgates a standard approach to calculating counterparty credit risk and replaces something that was called the SEM. So, so yeah, actually replaces the SEM, which is the current exposure method and also the SA, which is the standardized approach method to calculating counterparty credit risk. And it's far more sensitive than those two models, which is why I think we've seen a lot of effects in the FX market which we may go into in a bit more detail later.
Chris: UMR are the, as I said earlier, the uncleared margin rules. There's two facets to these rules. The first is the exchange of variation margin and the second is the exchange of initial margin variation margin. Those requirements have been in place since 2017. Critically didn't apply to FX forwards and swaps.
Chris: So all of these requirements are quite interrelated. But this is one of the reasons why we've seen a bit of an impact from SA-CCR in the FX market. The initial margin rules have really been implemented in a staged way, and the reason for that is initial margin is a lot more expensive than variation margin. So the view from the regulators was that the industry needed more time to prepare for the IM requirements as opposed to the VM ones. The last tranche of rules went live in September last year.
Chris: And this is where if firms had an average aggregate notional amount or an ANA on their derivative portfolios of more than 8 billion euros and they got captured by those initial margin requirements. So, you know, when the rules really started coming into effect, the ANA was around $3 trillion from recollection. So very few institutions other than the really large market makers were affected.
Chris: Now we've got a huge swathe of buy side firms who have been caught by that because of the lowering thresholds. So really, yeah, we're starting to see the final convulsions, if you like, of these rolled implementation since the financial crisis and trying to make the financial system more resilient.
Mike: So Chris you've got the introduction of these regulatory requirements. How has FX trading been affected by them?
Chris: So I think it's very much an evolving story at the moment. So in particular with SA-CCR, we have observed a widening of spreads in uncollateralized short dated swaps and forwards. So these were the swaps and forward instruments that were heavily affected by SacSA-CCRca because they weren't subject to the variation margin rules.
Chris: So the cost of the charges were higher. So there was a report in The Full FX about a year ago which reported that one of the largest market makers on the street had started widening spreads in response to SSA-CCR and had in some instances actually stopped quoting or pricing in those instruments altogether. So that's obviously a very big impact.
Chris: That particular market maker was normally around one or two in in the general rankings. They've dropped to a much lower than that now. So that's obviously quite a big impact. What's been difficult to tell is whether that was idiosyncratic or whether that's generally across the industry. So about a year ago, we also saw a bit of a study that looked to regress the data from the implementation of SA-CCR through to today.
Chris: And the way it looked to do that was to basically take normalized spreads and then regress for the effect of SA-CCR. That study did see an effect from SA-CCR across the industry, but it wasn't really conclusive. If I'm honest, and I think one of the biggest issues that we've seen to date is while we saw widening, there's been a lot of macro shocks that have hit the industry during that period.
Chris: So we've had the Ukraine war and we've obviously had interest rate movements, we've had high inflation. So, you know, all of those sort of macro events have led to greater volatility. And yeah, that's been particularly the case in currency pairs, but also in the G10 ones which have been most affected by SA-CCR because of these variation margin requirements.
Chris: So I think it's an unclear story at the moment. Undoubtably SA-CCR has had an effect on the cost of capital, but whether it's been significant enough to really explain the widening spreads that was seen, I think remains to be seen. I think in the Uncleared, yeah, in response to uncleared margin rules what we have seen is a substantial pickup in clearing.
Chris: And the reason for that is and this is particular in the in the interbank and the market in particular- which you know anecdotally we can see from the data is nearly entirely cleared now. The reason for that is obviously the collateralization charges are generally lower than the bilateral non cleared margining charges. So of course it's a very economic reason why the banks have moved to clearing as a result, we haven't necessarily seen the same pickup in the dealer decline space and we thought we might have seen that as a result of the IM rules coming into force last September.
Chris: I think time will tell on this one. I suspect there might be operational issues. Why we haven't seen a move to clearing there. But it's interesting that there are clear divergences in the interbank space in the and the dealer to customer space. And as a result of those UMR rules coming into force. So I think if I could summarize all of that, there have definitely been impacts both to the cost of capital and to clearing workflows, but maybe not as decisive as we might have anticipated when those rules are first getting promulgated.
Mike: So what are we doing to help clients with SA-CCR and UMR? What's LSEG doing Chris?
Chris: Well, I think there's a number of things that LSEG can do given our core competencies.
Chris: So the first is that towards the end of this year, we will be launching an entirely cleared India central middle order book in the interbank space where between us and Singapore and the US.
Chris: And the reason for that or the benefit to clients of that central limited order book will be that they will be able to trade MDFs in a standard manner and have it put straight through each clearing. So that will lower their UMR charges, but also it will also lower their SA-CCR charges as well, because if you clear trades, it invites a far lower SA-CCR charge than if you do not.
Chris: So that will help on our dealers to customer market FXAll we did launch a post-trade clearing service by settlement center last year. We're seeing some pickup in that, not substantial, but we know if clients are interested in that service to really lower or to remove the URM charges, you won't lower your collateral charges because you still have to post collateral to clear, but you’ll certainly lower the cost there and we can help out in that space.
Mike: And of course going down the road there going to be more developments in the future in this area. So what's, LSEG doing to help clients with those developments?
Chris: Yeah, I think we we can probably anticipate a number of changes. I mean, the first one, which I'll just highlight and not go into any detail on are the Edinburgh reforms that have been announced in the UK.
Chris: I think what we're most closely monitoring there, any divergences that start to occur in the prudential space between the UK, the EU and the UK and the US as a result of those reforms. I think, you know, given the economic situation in the UK, there may be a temptation to reduce some of the requirements in that space to try to stimulate economic growth.
Chris: We'll see what happens. I think the biggest one that's on the horizon at the moment is the fundamental review of the trading book or FRTB. so FRTB very quickly is the requirement to capitalize market risk. And it's a it's a very complicated set of rules and standards that have been put forth from the BCBS. And what we're seeing at the moment is divergences not just in implementation timelines but also in standards.
Chris: So if I just focus on the implementation timelines first, I think, you know, for the UK, the EU and Australia, we're expecting go live to be in January 2025. In Hong Kong, we're expecting gold to be July this year and in Japan, in Canada we're anticipating it to be early 2024 and in the US we don't actually know.
Chris: So, you know, this is this is giving everyone a lot of headaches at the moment. And then in terms of the divergences in standards, what we're saying is that the EU, which I should anticipate, was the first out the bloc and the BCBS put these standards for publish. They've set the law up in the EU to very much reflect the EU banking industry.
Chris: So for example, there's lower charges on carbon trading, whereas we may not see that in the UK or the US. So there are very subtle divergences in how the different jurisdictions are actually implementing this. That all adds up to a big compliance headache for our banking clients. We can't necessarily help with that, unfortunately, that's just a fact of life and the banks are, you know, pretty wise to complexity and regulatory change.
Chris: Now they've been dealing with over a decade of it. Where we can help is in data so FRTB is going to be incredibly data intensive in terms of the inputs that are required for whichever model banks choose to use. Under the FRTB we obviously have a pretty vast suite of data products that we can use to help our clients and without going into too much detail, I think I'll just leave it with, you know, if our clients have any questions on that, we're here to help and get in touch.
Mike: Our thanks to Chris Leonard Appleton. I'm Mike Cahill, and thank you for listening.
