Margin conundrums - Markit

IM

Margin
conundrums
While regulation pertaining to IM might look simple
on paper, its implementation will be more challenging.
Markit’s Paul Jones investigates.

Paul Jones , director, analytics at If we want to understand the challenges facing 36 per cent of the initial margin posted by Lehman
Markit. regulatory authorities in setting standards for Bros was required to meet replacement and hedging
margining of bilateral business, it is worth bearing costs of their portfolio, according to industry sources.
in mind a few principles likely to provide a
framework for a regulator’s thinking. In addition, there were concerns in some quarters
The objective of bilateral initial margin is to reduce that additional capital requirements under Basel III,
systemic risk and incentivise the clearing of over-the- including the Credit Valuation Adjustment Value-at-
counter (OTC) derivatives. Systemic risk, as seen Risk (CVA VaR) charge, were not sufficient incentives
during the financial crisis, is caused by the for participants to clear. The cost of capital did not
interconnectedness of financial institutions. One always exceed the cost of capital contribution to the
firm’s default can create a domino effect, often CCP default fund made by clearing members.
requiring state intervention as a last resort. By
increasing the amount of collateral that must be Given its success during the Lehman default, the
collected from uncleared derivatives, regulators seek idea of applying CCP-style margining to the world of
to ensure that a defaulting dealer will already have bilateral derivatives received regulatory support
provided sufficient collateral. This avoids the need for because it seemed consistent with the objective of
absorbing credit risk losses in the capital cushions of ensuring the safety of the financial system. However,
healthy banks. despite some perceived similarities between initial
margin within CCPs and the use of IM for uncleared
Initial margin is intended to give both over the counter derivatives (OTC) a close
counterparties to a Credit Support Annex (CSA) a examination reveals some stark differences. The delays
buffer of over collateralisation to absorb losses during in the implementation of the rules bear testament to
the close out of the defaulting party’s portfolio, the fact that regulators and market participants are
especially at a time when the market is expected to be having to work very hard to avoid unintended
under stress and highly volatile. consequences, which could create a situation where the
regulations increase systemic risk.
Initial margin is a central part of the risk mitigation
used by central counterparties (CCPs). It successfully Bilateral and CCP
absorbed the losses of the Lehman default when just
These challenges stem from the fact that bilateral
Financial counterparties must report margining differs in two main ways from CCP
unresolved disputes greater than €15m margining. First, in the complexity and liquidity of
and outstanding for at least 15 days to the products they margin and second, in the processes
their regulator. around which margin calls can be disputed.

The population of uncleared derivatives will include
products that are too complex and too illiquid to clear
and risk manage within a CCP. The same risks that
are currently borne by capital on banks’ balance-
sheets will have to be absorbed by collateral held in a
custody account. This means that the risk models
used to calculate initial margin must handle many of

32 Summer 2014

the same exposures currently treated within banks’
internal capital models. Banks’ capital models have
always been subject to regulatory supervision,
requiring banks to carry out significant testing.

The casual observer might think that if banks are
already modelling these risks then it’s just a question
of using these same risk models. Indeed, some firms
are looking to leverage some of these capabilities.
Banks’ internal capital models attempt to capture
illiquid and hard to observe risks, such as basis risk
and correlation and must make significant subjective
assumptions. Post-crisis, they have come under
significant scrutiny as many of these assumptions
failed and banks were regarded as undercapitalised
as a result. A comparative analysis was carried out by
the Basel Committee on Banking Supervision
(BCBS) in 2013 and found a very wide variation
between different firms’ calculations on the same
portfolio. For example, in a portfolio containing a
two-year swaption on a 10 year interest rate swap,
the largest VaR was five times greater than the
smallest.

Capital modelling Events from the crisis have prompted increased $32bn
regulations around margin calculations and capital
However, capital modelling is a matter that is internal requirements for bilateral collateralised exposures. They margin calls received by AIG
to banks’ balance sheets. Any inaccuracies in the also illustrate the difficulty of calculating the valuations in Q2 2008.
models, while serious, are a matter for the bank and its used for variation margin on some illiquid products.
prudential regulator as part of a model review process These difficulties are further compounded when
typically over a period of months. Conversely, calculating initial margin. It requires risk modelling
unexpected or erroneous margin calls on OTC that presents the same challenges banks have faced with
derivatives can have serious effects by creating short-
term liquidity squeezes, as was seen when AIG received
$32bn in margin calls in Q2 2008. Even within the
cleared world market disciplines, regulators are
working to ensure that potential model and operational
risk within CCP margining models do not themselves
become a source of the systemic risk by creating short-
term liquidity spikes due to overstated margin.

In contrast to clearing, when the margin calculated
by the CCP must be paid in order to avoid a default,
counterparties that are unwilling or unable to meet
margin demands requested of them may begin
a dispute process. This can be time consuming and
occasionally require third-party intervention to
provide independent margin calculations. In July
2007 Goldman Sachs sent a $1.8bn collateral call to
AIG, according to the US government’s Financial
Crisis Inquiry Report. AIG disputed the valuations
that Goldman was using for credit default swaps on
asset backed securities. After protracted discussions,
with both sides agreeing that the market was illiquid
and accurate pricing was challenging, AIG ended up
paying only $450m in August. In September 2007
Goldman Sachs made a further call for $1.8bn that
AIG did not pay.

Variation margin disputes have also become more
complex since the crisis as firms are diverging in terms
of their view on the appropriate credit risks, funding
cost risks and balance sheet costs to incorporate in
derivative pricing including issues such as overnight
index swaps discounting. This trend is only set to
continue and a Markit survey of heads of credit value
adjustment at 15 dealers indicated that six expected
initial margin for uncleared to be incorporated within
accounting valuations.

Summer 2014 33

IM

In a portfolio containing a two-year swaption Banks frequently involved in disputes are subject
on a 10-year interest rate swap, the largest to increased disputes capital charges. Under
VaR was five times greater than the smallest. European Market Infrastructure Regulation
(Emir), firms must have procedures to record the
their internal risk models. Possible causes of differences length of time, the counterparty and the amount
in data that may cause a dispute in variation margin disputed. Firms must establish a mechanism to
include disparities in trade details, missing trades, resolve disputes in a timely manner and establish a
different curves used to value trades. In the case of specific process for disputes outstanding longer
initial margin additional differences may give rise to than five business days. Financial counterparties
disputes, over issues such as risk factor modelling and must report unresolved disputes greater than €15m
correlations. The variation of these assumptions and outstanding for at least 15 days to their
between firms is highlighted by the Basel III Regulatory regulator.
Consistency Assessment Programme (RCAP) described
above and has led Isda to spearhead a standardised As well as margin call disputes becoming more
initial margin model. However, differences can still complex, there are a number of factors which mean
remain in terms of how firms calculate trade sensitivities that the number of margin calls is expected to
or implement the model. Many participants see the increase significantly. The initial margin
need for a third party offering to resolve those requirements for bilateral trades will create a new
differences and minimise disputes. CSA (variation margin and initial margin) which
must be margined separately from the old CSA (VM
Dispute mechanism only). There will also be fragmentation across CCPs,
increased segregation of funds and potentially the
Regulators have moved to prevent banks using a break down of margin into currency buckets.
dispute mechanism to avoid paying for margin.
 These new regulations all combine to create an
intensively challenging period for market participants
and regulators alike. But the proof of the pudding
will be in the eating, and only time will tell how
successful they have been.

REDUCING RISK

Bill Hodgson, owner The OTC Space. New margin requirements resources to replicate each other’s margin models, and
will increase protection from therefore counterparties would never be sure who was
default and create a more level right.
playing field.
The BIS regulations require each firm to exchange
F rom December 2015, all over-the-counter IM individually. Thus those concerned will aim to
(OTC) derivatives trades must be covered deliver around the same amount of IM as they
by new margin arrangements specified by receive, to match funding costs and credit risks of the
the Bank for International Settlements. The exchange of assets.
purpose is either to protect parties from
default risk, to avoid arbitrage by not clearing trades The Isda proposal mirrors the approach of central
and keeping a level playing field. All parties outside clearing counterparties (CCPs) in that it proposes an
clearing must begin to exchange margin using a IM model in line with the CPSS-IOSCO Working
similar model to those in clearing, namely initial and Group on Margin Requirements (WGMR) historic
variation margin. Banks currently pay variation value-at-risk model, using a five-year market history
margin using their existing credit support annexe period, a 99 per cent confidence level and a 10-day
(CSA) agreements, so adding initial margin is the holding period. These parameters are similar to those
implementation challenge. of the major CCPs, although each has its own specific
variation.
The International Swaps and Derivatives
Association (Isda) on behalf of its members has Isda have defined nine principles that their model
responded to this new requirement by proposing a must support. (See table)
‘standard’ model for initial margin (Simm). Isda
points out that if every OTC user implemented their Achieving these principles gives rise to several
own proprietary model, nobody would have the challenges, which include:
l E ach firm uses its own sources of market data and

quality review methods
l E ach firm has its own proprietary pricing models
l T o achieve speed a sensitivity based approach is

suggested, which will also be influenced by pricing
models
l W here do the historic scenarios come from?
Will these be developed and distributed by a
central body?
l W ho calibrates each bank’s implementation to

34 Summer 2014

Principle Explanation

1. Non-procyclical Margins are not subject to continuous change due to changes in market volatility

2. Ease of replication Easy to replicate calculations performed by a counterparty, given the same inputs and trade
populations

3. Transparency Calculation can provide contribution of different components to enable effective dispute
resolution

4. Quick to calculate Low analytical overhead to allow quick calculations and re-runs of calculations as needed
by participants

5. Extensible Methodology is conducive to addition of new risk factors and/or products as required by the
industry and regulators

6. Predictability IM demands need to be predictable to preserve consistency in pricing and to allow
participants to allocate capital against trades

7. Costs Reasonable operational costs and burden on industry, participants, and regulators

8. Governance Recognises appropriate roles and responsibilities between regulators and industry

9. Margin appropriateness Use with large portfolios does not result in vast overstatements of risk. Recognition of risk
factor offsets within the same asset class.

verify it meets minimum standards to be reduce market risk in another.
compliant with these principles? To increase efficiency, Isda proposes a sensitivity-
l H ow will each firm map the many disparate trade
structures into a common asset class structure for based approach; that is, precalculate the ‘greeks’ for a
pricing and risk analysis? portfolio and multiply by the risk factors, a quicker
One Isda proposal which deviates from typical process than full mathematical recalculation of all
clearing house practice is not to update the historic trades versus all risk factors and historic scenarios. The
scenarios on a regular basis, but to make this an reason for this approximation approach is the need for
annual event, driven by a central regulatory body. measurement of the amount of IM pre-execution for
The reasoning is to avoid models being oversensitive cost and limit purposes. For a bank to quote a price to
to market conditions and meet principle number an end-user, for many trades per day, the incremental
one. margin on its ‘house’ portfolio would be so resource
The CPSS-IOSCO proposals require IM to be intensive as to bring price-making to a stand-still.
calculated in asset class silos for rates, equity, credit Hence the shortcut to deliver an IM number at a
and commodities, based on the assumption that the reasonable cost in a reasonable amount of time.
correlation across those classes breaks down in a
stressed market. Isda points out that there will be One conclusion we can draw is that there is still
difficulties with this approach, as some products such time for this SIMM to be developed. This may be a
as “option structures embedded in convertible bonds golden opportunity for software vendors capable of
contain interest rate risk, credit risk and equity risk delivering a SIMM implementation in an affordable
each in material amounts with the dominant one manner. Major banks have the resources to extend
dependent on market conditions” and lists other their existing risk management framework to
pitfalls, such as using trades in one asset class to implement SIMM, but many end-users will not.
Perhaps we will see more use of the Internet cloud to
provide a platform for small volume firms to achieve
the necessary calculations.

THE RULE BOOK

Regulatory bodies agree to designed not only to compensate for the additional Marcus Schüler, Markit head of
disagree on how to enforce IM risk that counterparties would be exposed to but also regulatory affairs.
supervision. Marcus Schüler, to encourage central clearing. In 2011, the G20
Markit’s head of regulatory agreed to add margin requirements on non-centrally-
affairs, explains. cleared derivatives to the reform programme and
called upon the Basel Committee on Banking
A s part of the 2009 Pittsburgh Supervision (BCBS) and International Organization
commitments on OTC derivatives, G20 of Securities Commissions (IOSCO) to develop
leaders agreed that non-centrally-cleared consistent global standards.
derivative contracts should be subject to
higher capital requirements. This was Starting in April 2011, various global regulatory
authorities, including the Commodity Futures
Trading Commission (CFTC), the Securities and
Exchange Commission (SEC), the US banking
regulators and the European Supervisory Authorities
(ESAs), each came up with their own margin rules to
implement the G20 commitment. However, it

Summer 2014 35

IM

Top: The G20 Saint Petersburg quickly became apparent that each regulatory l T he WGMR proposes allowing rehypothecation of
Summit 2013 authority had different views on how to appropriately the collateral received under 12 strict requirements,
design a margin regime. Differences between for example its use “only for purposes of hedging
regulators extended to fundamental questions such as the IM collector’s derivatives position arising out of
whether both counterparties should be required to transactions with customers for which IM was
collect margin for all transactions or whether only collected, and it must be subject to conditions that
one of them would need to do so for some deals, protect the customer’s rights in the collateral”. By
depending on the nature of the counterparties. contrast, the ESAs proposed to not permit
rehypothecation at all. This is based on its view that
In October 2011 the CPSS-IOSCO Working the restrictions set by the WGMR would only be of
Group on Margin Requirements (WGMR) was limited use in the European context and that ruling
formed with the goal of creating internally consistent out rehypothecation altogether would help simplify
standards. The group published its final principles to the overall framework.
establish a globally agreed framework for margin
requirements in autumn last year. In its final report, l T he ESAs propose to allow the use of a wider set of
the global regulators voiced concern about the collateral compared with the WGMR. However,
potential impact that the margin requirements for they would also require the use of a standardised
uncleared derivatives could have on market haircut schedule for those instruments.
functioning and left some areas open for further
investigation. Specifically, a monitoring group was l In relation to IM calculation, the ESAs seem to
established to consider the overall efficiency and share the WGMR’s concerns about the potential for
appropriateness of the margin methodologies and disputes between counterparties about IM amounts
standards, including “exploring the possible that they calculate on the basis of their proprietary
alignment of the model and standardised schedule models. To address such concerns, the ESAs are
approaches for calculating initial margin, and open to discussing all options and would also allow
assessing the potential procyclicality of the margin for a wider use of model-based calculations or
requirements”. The WGMR also provided additional standards.
time for implementation with the first stage starting
in December 2015 for transactions between the very l T his contrasts with the WGMR’s more restrictive
biggest firms (with more than $3trn in uncleared approach, which states that a “model must be
derivatives outstanding) and full implementation approved for use within each jurisdiction and by
envisaged in December 2019 (when this threshold each institution seeking to use the model”.
would drop to $8bn).
What’s next?
Divergence
In Europe, following consultation, the ESAs are
The ESAs are the first regulatory authorities to come up expected to submit their regulatory technical
with new rules following the publication of the standards (RTS) to the European Commission by
IOSCO framework. Their proposals are in line with the the end of 2014. Adoption of these RTS is likely in
IOSCO principles, including implementation timing, early 2015, with application expected from December
minimum thresholds, minimum transfer amounts and 1st, 2015. Other jurisdictions are also likely to
treatment of physically settled FX forwards. However, recommend new margin rules over the coming
several areas of divergence are notable: months. Specifically, the CFTC is likely to come up
with its rules by midyear and the contents are likely to
be consistent with the IOSCO framework.