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If we want to understand the challenges facing regulatory authorities in setting standards for margining of bilateral business, it is worth bearing in mind a few principles likely to provide a framework for a regulator’s thinking.The objective of bilateral initial margin is to reduce

systemic risk and incentivise the clearing of over-the-counter (OTC) derivatives. Systemic risk, as seen during the financial crisis, is caused by the interconnectedness of financial institutions. One firm’s default can create a domino effect, often requiring state intervention as a last resort. By increasing the amount of collateral that must be collected from uncleared derivatives, regulators seek to ensure that a defaulting dealer will already have provided sufficient collateral. This avoids the need for absorbing credit risk losses in the capital cushions of healthy banks.

Initial margin is intended to give both counterparties to a Credit Support Annex (CSA) a buffer of over collateralisation to absorb losses during the close out of the defaulting party’s portfolio, especially at a time when the market is expected to be under stress and highly volatile.

Initial margin is a central part of the risk mitigation used by central counterparties (CCPs). It successfully absorbed the losses of the Lehman default when just

36 per cent of the initial margin posted by Lehman Bros was required to meet replacement and hedging costs of their portfolio, according to industry sources.

In addition, there were concerns in some quarters that additional capital requirements under Basel III, including the Credit Valuation Adjustment Value-at- Risk (CVA VaR) charge, were not sufficient incentives for participants to clear. The cost of capital did not always exceed the cost of capital contribution to the CCP default fund made by clearing members.

Given its success during the Lehman default, the idea of applying CCP-style margining to the world of bilateral derivatives received regulatory support because it seemed consistent with the objective of ensuring the safety of the financial system. However, despite some perceived similarities between initial margin within CCPs and the use of IM for uncleared over the counter derivatives (OTC) a close examination reveals some stark differences. The delays in the implementation of the rules bear testament to the fact that regulators and market participants are having to work very hard to avoid unintended consequences, which could create a situation where the regulations increase systemic risk.

Bilateral and CCP These challenges stem from the fact that bilateral margining differs in two main ways from CCP margining. First, in the complexity and liquidity of the products they margin and second, in the processes 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

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

Margin conundrums

Paul Jones , director, analytics at Markit.

Financial counterparties must report unresolved disputes greater than €15m and outstanding for at least 15 days to their regulator.

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$32bn margin calls received by AIG in Q2 2008.

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 modellingHowever, capital modelling is a matter that is internal to banks’ balance sheets. Any inaccuracies in the models, while serious, are a matter for the bank and its prudential regulator as part of a model review process typically over a period of months. Conversely, unexpected or erroneous margin calls on OTC 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.

Events from the crisis have prompted increased regulations around margin calculations and capital requirements for bilateral collateralised exposures. They also illustrate the difficulty of calculating the valuations used for variation margin on some illiquid products. These difficulties are further compounded when calculating initial margin. It requires risk modelling that presents the same challenges banks have faced with

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their internal risk models. Possible causes of differences in data that may cause a dispute in variation margin include disparities in trade details, missing trades, different curves used to value trades. In the case of initial margin additional differences may give rise to disputes, over issues such as risk factor modelling and correlations. The variation of these assumptions between firms is highlighted by the Basel III Regulatory Consistency Assessment Programme (RCAP) described above and has led Isda to spearhead a standardised initial margin model. However, differences can still remain in terms of how firms calculate trade sensitivities or implement the model. Many participants see the need for a third party offering to resolve those differences and minimise disputes.

Dispute mechanismRegulators have moved to prevent banks using a dispute mechanism to avoid paying for margin.

Banks frequently involved in disputes are subject to increased disputes capital charges. Under European Market Infrastructure Regulation (Emir), firms must have procedures to record the length of time, the counterparty and the amount disputed. Firms must establish a mechanism to resolve disputes in a timely manner and establish a specific process for disputes outstanding longer than five business days. Financial counterparties must report unresolved disputes greater than €15m and outstanding for at least 15 days to their regulator.

As well as margin call disputes becoming more complex, there are a number of factors which mean that the number of margin calls is expected to increase significantly. The initial margin requirements for bilateral trades will create a new CSA (variation margin and initial margin) which must be margined separately from the old CSA (VM only). There will also be fragmentation across CCPs, increased segregation of funds and potentially the break down of margin into currency buckets.

 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.

From December 2015, all over-the-counter (OTC) derivatives trades must be covered by new margin arrangements specified by the Bank for International Settlements. The purpose is either to protect parties from

default risk, to avoid arbitrage by not clearing trades and keeping a level playing field. All parties outside clearing must begin to exchange margin using a similar model to those in clearing, namely initial and variation margin. Banks currently pay variation margin using their existing credit support annexe (CSA) agreements, so adding initial margin is the implementation challenge.

The International Swaps and Derivatives Association (Isda) on behalf of its members has responded to this new requirement by proposing a ‘standard’ model for initial margin (Simm). Isda points out that if every OTC user implemented their own proprietary model, nobody would have the

resources to replicate each other’s margin models, and therefore counterparties would never be sure who was right.

The BIS regulations require each firm to exchange IM individually. Thus those concerned will aim to deliver around the same amount of IM as they receive, to match funding costs and credit risks of the exchange of assets.

The Isda proposal mirrors the approach of central clearing counterparties (CCPs) in that it proposes an IM model in line with the CPSS-IOSCO Working Group on Margin Requirements (WGMR) historic value-at-risk model, using a five-year market history period, a 99 per cent confidence level and a 10-day holding period. These parameters are similar to those of the major CCPs, although each has its own specific variation.

Isda have defined nine principles that their model must support. (See table)

Achieving these principles gives rise to several challenges, which include:l Each firm uses its own sources of market data and

quality review methodsl Each firm has its own proprietary pricing modelsl To achieve speed a sensitivity based approach is

suggested, which will also be influenced by pricing models

l Where do the historic scenarios come from? Will these be developed and distributed by a central body?

l Who calibrates each bank’s implementation to

REDUCING RISK

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.

Bill Hodgson, owner The OTC Space.

New margin requirements will increase protection from default and create a more level playing field.

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Marcus Schüler, Markit head of regulatory affairs.

verify it meets minimum standards to be compliant with these principles?

l How will each firm map the many disparate trade structures into a common asset class structure for pricing and risk analysis?

One Isda proposal which deviates from typical clearing house practice is not to update the historic scenarios on a regular basis, but to make this an annual event, driven by a central regulatory body. The reasoning is to avoid models being oversensitive to market conditions and meet principle number one.

The CPSS-IOSCO proposals require IM to be calculated in asset class silos for rates, equity, credit and commodities, based on the assumption that the correlation across those classes breaks down in a stressed market. Isda points out that there will be difficulties with this approach, as some products such as “option structures embedded in convertible bonds contain interest rate risk, credit risk and equity risk each in material amounts with the dominant one dependent on market conditions” and lists other pitfalls, such as using trades in one asset class to

reduce market risk in another. To increase efficiency, Isda proposes a sensitivity-

based approach; that is, precalculate the ‘greeks’ for a portfolio and multiply by the risk factors, a quicker process than full mathematical recalculation of all trades versus all risk factors and historic scenarios. The reason for this approximation approach is the need for measurement of the amount of IM pre-execution for cost and limit purposes. For a bank to quote a price to an end-user, for many trades per day, the incremental margin on its ‘house’ portfolio would be so resource intensive as to bring price-making to a stand-still. Hence the shortcut to deliver an IM number at a reasonable cost in a reasonable amount of time.

One conclusion we can draw is that there is still time for this SIMM to be developed. This may be a golden opportunity for software vendors capable of delivering a SIMM implementation in an affordable manner. Major banks have the resources to extend their existing risk management framework 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

As part of the 2009 Pittsburgh commitments on OTC derivatives, G20 leaders agreed that non-centrally-cleared derivative contracts should be subject to higher capital requirements. This was

designed not only to compensate for the additional risk that counterparties would be exposed to but also to encourage central clearing. In 2011, the G20 agreed to add margin requirements on non-centrally-cleared derivatives to the reform programme and called upon the Basel Committee on Banking Supervision (BCBS) and International Organization of Securities Commissions (IOSCO) to develop consistent global standards.

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

Regulatory bodies agree to disagree on how to enforce IM supervision. Marcus Schüler, Markit’s head of regulatory affairs, explains.

Principle Explanation1. Non-procyclical Margins are not subject to continuous change due to changes in market volatility2. Ease of replication Easy to replicate calculations performed by a counterparty, given the same inputs and trade

populations3. Transparency Calculation can provide contribution of different components to enable effective dispute

resolution4. Quick to calculate Low analytical overhead to allow quick calculations and re-runs of calculations as needed

by participants5. Extensible Methodology is conducive to addition of new risk factors and/or products as required by the

industry and regulators6. Predictability IM demands need to be predictable to preserve consistency in pricing and to allow

participants to allocate capital against trades7. Costs Reasonable operational costs and burden on industry, participants, and regulators8. Governance Recognises appropriate roles and responsibilities between regulators and industry9. Margin appropriateness Use with large portfolios does not result in vast overstatements of risk. Recognition of risk

factor offsets within the same asset class.

IM

quickly became apparent that each regulatory authority had different views on how to appropriately design a margin regime. Differences between regulators extended to fundamental questions such as whether both counterparties should be required to collect margin for all transactions or whether only one of them would need to do so for some deals, depending on the nature of the counterparties.

In October 2011 the CPSS-IOSCO Working Group on Margin Requirements (WGMR) was formed with the goal of creating internally consistent standards. The group published its final principles to establish a globally agreed framework for margin requirements in autumn last year. In its final report, the global regulators voiced concern about the potential impact that the margin requirements for uncleared derivatives could have on market functioning and left some areas open for further investigation. Specifically, a monitoring group was established to consider the overall efficiency and appropriateness of the margin methodologies and standards, including “exploring the possible alignment of the model and standardised schedule approaches for calculating initial margin, and assessing the potential procyclicality of the margin requirements”. The WGMR also provided additional time for implementation with the first stage starting in December 2015 for transactions between the very biggest firms (with more than $3trn in uncleared derivatives outstanding) and full implementation envisaged in December 2019 (when this threshold would drop to $8bn).

DivergenceThe ESAs are the first regulatory authorities to come up with new rules following the publication of the IOSCO framework. Their proposals are in line with the IOSCO principles, including implementation timing, minimum thresholds, minimum transfer amounts and treatment of physically settled FX forwards. However, several areas of divergence are notable:

lThe WGMR proposes allowing rehypothecation of the collateral received under 12 strict requirements, for example its use “only for purposes of hedging the IM collector’s derivatives position arising out of transactions with customers for which IM was collected, and it must be subject to conditions that protect the customer’s rights in the collateral”. By contrast, the ESAs proposed to not permit rehypothecation at all. This is based on its view that the restrictions set by the WGMR would only be of limited use in the European context and that ruling out rehypothecation altogether would help simplify the overall framework.

lThe ESAs propose to allow the use of a wider set of collateral compared with the WGMR. However, they would also require the use of a standardised haircut schedule for those instruments.

lIn relation to IM calculation, the ESAs seem to share the WGMR’s concerns about the potential for disputes between counterparties about IM amounts that they calculate on the basis of their proprietary models. To address such concerns, the ESAs are open to discussing all options and would also allow for a wider use of model-based calculations or standards.

lThis contrasts with the WGMR’s more restrictive approach, which states that a “model must be approved for use within each jurisdiction and by each institution seeking to use the model”.

What’s next?In Europe, following consultation, the ESAs are expected to submit their regulatory technical standards (RTS) to the European Commission by the end of 2014. Adoption of these RTS is likely in early 2015, with application expected from December 1st, 2015. Other jurisdictions are also likely to recommend new margin rules over the coming 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.

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