More questions than answers in EU margin draft

David Wigan
Published on:

Draft rules permit internal modelling; two sides to contract unlikely to agree.

The recent publication of European draft regulatory standards for margin requirements for uncleared derivatives has raised serious concerns about the use of internal models for margin calculations.

The key issue facing regulators and market participants is that two parties to a derivative contract are permitted under the proposals to use internal models to calculate margin levels for any bilateral transaction. But what should happen when the parties disagree?

"Initial margin models require many data sources to function, including historical curve points, FX rates and volatilities – plus firms have their own methods of filtering scenarios and selecting the final result," says Bill Hodgson, CEO at The OTC Space. "That means two firms working independently to arrive at a bilateral initial margin amount are unlikely to ever reconcile their own figures."

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Initial margin (IM) is a key element of the systemic security offered by clearing houses and its worth was illustrated during the financial crisis when just 36% of the margin posted by Lehman Brothers was required to cover its portfolio replacement and hedging costs. 

That episode, alongside concerns that capital charges might not be sufficient to drive over-the-counter business into clearing, enamoured regulators to the idea of initial margin for uncleared contracts. A long-running process of proposals and consultations on both sides of the Atlantic has followed.

Different paths

Amid concern that US and European regulators seemed in 2012 and 2013 to be following diverging paths (sometimes in respect of fundamental aspects such as who should pay) the International Organization of Securities Commissions (Iosco) in September sought to harmonize standards by publishing guidelines for national regulators to follow.

Europe was first to react and its proposals were published last month. The European draft, authored jointly by the European Securities and Markets Agency (Esma), the European Banking Agency (EBA) and the European Insurance and Occupational Pensions Authority (EIOPA), prescribes the minimum amount of initial and variation margin to be posted, the calculation methodologies to be used and eligible capital. The document also stipulates thresholds to be applied to the posting of collateral.

bill hodgson

"Two firms working independently to arrive at a bilateral initial margin amount are unlikely to  ever reconcile their own figures"
-Bill Hodgson, The OTC Space

Counterparties are required to collect collateral if they are financial counterparties or non-financial counterparties above the clearing threshold. 

If from December 2019 at least one of the counterparties belongs to a "group" with an aggregate month-end average notional amount of non-centrally cleared derivatives for June, July and August of the year below €8 billion then initial margin does not need to be posted. 

Higher thresholds apply from December 1 2015, when the regulatory technical standards are proposed to come into force.

Initially, those market participants with an aggregate month-end average notional amount of non-centrally cleared derivatives that exceed €3 trillion will be subject to the IM requirements, with that number decreasing every year before 2019. However, margin only starts to be paid once the requirement reaches €50 million.

The draft European standards expressly recognize the potential conflict caused by the bilateral nature of margin calculations.

"The use of internal models in the legislation concerning prudential regulation is not new and is widespread in the banking and insurance sectors," the paper says. "Similarly, the use of margin models for the calculation of the margin requirements will be a crucial aspect in the implementation of this framework. However, contrary to the existing practice, this proposal will necessitate that counterparties agree on the results of the margin models on an ongoing basis and this raises a substantial number of new issues."

The potential for disagreement is magnified by the complex and illiquid nature of uncleared business, compared with its standardized cleared counterpart. Meanwhile, the value-at-risk based models likely to be used are notoriously unpredictable, as was shown in a Basle Committee study last year that reported a wide variation on model outputs by a group of firms asked to calculate capital levels on the same portfolio.

In light of the potential for disagreement over margin it might be sensible for the industry to consider employing third parties to calculate independent margin levels, the paper says, an observation that has not gone unnoticed at industry association Isda and in the private sector.

"If you are using an internal model for capital it makes a lot of sense to adapt that model for margins," says Marcus Schueler, head of regulatory affairs at Markit Group. "Of course the key observation is that your counterparties are directly impacted by your model, which is why it makes a lot of sense for the industry to look for some kind of objective standard."

Isda has taken a lead on the issue and in December published proposals for a standard initial margin model (Simm).

The Isda proposal mirrors the approach seen at many clearing houses in that it proposes a model in line with the Basle Committee/Iosco Working Group on Margining Requirements (WGMR) requirements of an historical VaR model, using a five-year market history period, a 99% confidence level, and a 10-day holding period. Those parameters are similar to those used at major central counterparty clearing houses (CCPs), but with a longer holding horizon.