On 2 September 2013, the Basel Committee on Banking Supervision (“BCBS”) and the International Organization of Securities Commissions (“IOSCO”) published their final policy document regarding “Margin requirements for non-centrally cleared derivatives” (see this blog post for more detail).
Under the guidance, firms will be required to exchange initial margin (IM) on a gross basis. In calculating IM requirements, they may use a standard schedule or approved models. The standard schedule is provided in Appendix A to the final rules and details IM requirements (expressed as a percentage of notional amount), ranging from 1% (in the case of short-dated IRS) to 15% (in the case of equities and commodities). ISDA estimates that an additional EUR 8 trillion of collateral will be required by the industry in the event that standard schedules are used, as compared to EUR 0.7 trillion under model-based approaches. Given this, and the fact that specific methodologies for calculating IM must be agreed and recorded on execution of each transaction, ISDA’s preference for a model-based approach is understandable. Unfortunately, the final rules also require parties to derivatives contracts to have rigorous and robust dispute resolution procedures in place with their counterparty before execution of a transaction – a requirement with which it would be difficult to comply if all market participants were to use their own models and inputs.
On 10 December 2013, in an attempt to address these issues and to facilitate consistent regulatory governance and oversight, ISDA published a white paper on a “Standard Initial Margin Model” (SIMM) for Non-Cleared Derivatives. The white paper represents initial thoughts from ISDA’s SIMM Committee rather than a detailed methodology, on a common methodology for calculating IM. It makes a number of key assumptions regarding:
- General structure of margin calculations;
- Requirement for margin to meet a 99% confidence level of cover over a 10-day standard margin period of risk;
- Model validation, supervisory coordination and governance;
- Use of portfolio risk sensitivities (“Greeks”) rather than full revaluations; and
- Explicit inclusion of collateral haircut calculations within the portfolio SIMM calculation.
In addition, nine criteria have been identified which any SIMM should satisfy, being:
- Non-procyclical: the SIMM should not be explicitly linked to market levels or volatility, nor should scenarios automatically update with time. Instead the model should be updated periodically, for example annually, and then solely at the discretion of the global regulatory body;
- Ease of replication: ISDA recognises that a common model can only go part way to addressing the issue of replication as different inputs to even a standard model persist;
- Quick to calculate: ISDA believes that the calculation must be done within a few seconds, no matter how large or complex the underlying portfolio of trades;
- Extensible: the model will need to be easily extensible and amenable to the addition of new risk factors;
- Reasonable in terms of cost: ISDA believes that it is imperative that all covered entities be able to build or buy the model in order to facilitate access to non-cleared markets;
- Subject to appropriate governance: ISDA notes that while the industry will create a consensus around the approach to SIMM calculation, regulators should approve the risk factors involved in the calculation and the calibration of the model; and
- Margin appropriateness: ISDA considers that within an asset class (currency/rates, equities, credit and commodities), but not across asset classes, positions with offsetting risk factors should benefit from a lower IM requirement than were the positions margined separately.