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.”
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.
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.
“Two firms working independently to arrive at a bilateral initial margin amount are unlikely to ever reconcile their own figures”
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.
Incentive to clear
“The WGMR set a 10-day, 99% VaR requirement for internal initial margin models, which means that, all else being equal, there will be a higher initial margin requirement for non-cleared trades versus cleared. That is meant to act as an incentive to clear,” says Athanassios Diplas, senior adviser to the Isda board.
“The driver for the industry effort to create a standard initial margin model is that there would be a huge number of disputes if everyone used their own internal models. That would affect everyone, so we have a broad participation from both the buy and sell side on the project.”
Isda also highlights nine principles that models should follow, including non-procyclicality, ease of replication, transparency and predictability. The challenges of complying with some of those principles are substantial, as was pointed out by the Bank of England in its paper “An investigation into the procyclicality of risk-based initial margin models”, published this month.
“Common risk models are procyclical: margin requirements for the same portfolio are higher in times of market stress and lower in calm markets,” the central bank says. “This procyclicality can cause liquidity stress whereby parties posting margin have to find additional liquid assets, often at just the times when it is most difficult for them to do so.”
The paper recommends that CCPs and major dealers should disclose the procyclicality properties of their margin models, perhaps by reporting the proposed procyclicality measures. Isda, meanwhile, has proposed a longer calibration period, such as a year, for models.
“It seems unrealistic to expect that outside clearing the entire OTC derivatives industry would agree to one standard approach to VaR for bilateral margin amounts, so there remains a question on how firms with different margin models will reconcile and manage the credit risks as a result,” says The OTC Space’s Hodgson.