In September 2013, the Basel Committee on Banking Supervision (“BCBS”) and the Board of the International Organization of Securities Commissions (“IOSCO”) published guidelines on “Margin requirements for non-centrally cleared derivatives”. In December 2013, in response to these guidelines, ISDA published a paper proposing a standard initial margin model (“SIMM”). This briefing provides a brief outline of the BCBS-IOSCO guidelines and then looks at the SIMM proposal.
The BCBS-IOSCO guidelines are motivated by a globally perceived need in the light of the recent financial and economic crisis to reduce systemic risk from OTC derivatives. They articulate a series of key principles and requirements relating to the provision of margin (both initial and variation) for non-centrally cleared derivatives, taking into account among other things the liquidity impact of the proposals and the availability of eligible collateral to meet margin calls.
The guidelines set out eight key principles. In brief these are:
1. Appropriate margining practices should be in place with respect to all derivative transactions that are not centrally-cleared1.
3. The methodologies for calculating initial and variation margin should (i) be consistent and reflect both potential future exposure (initial margin) and current exposure (variation margin)4 and (ii) ensure that all counterparty risk exposures are fully covered with a high degree of confidence5.
4. Assets collected as margin should be highly liquid and, after applying an appropriate haircut, should be able to hold their value in a time of financial stress6.
5. Initial margin should be exchanged by both parties on a gross basis and held in a such a way as to ensure that it is immediately available to the collecting party or posting party on a counterparty default/insolvency7.
6. Transactions between a firm and its affiliates should be subject to appropriate regulation in a manner consistent with each jurisdiction’s legal and regulatory framework.
7. Regulatory regimes should be consistent and non-duplicative across jurisdictions8.
8. Margin requirements should be phased in over time9.
BCBS-IOSCO intends to set up a monitoring group in 2014, which may result in changes or refinements to the principles set out above as well as the detailed requirements that flow from them.
Standard Initial Margin Model - SIMM
In order to facilitate the introduction of the BCBS-IOSCO guidelines, ISDA has proposed a SIMM that could be used by market participants. Its December 2013 paper notes that a common methodology would have several key benefits, such as permitting timely and transparent dispute resolution and allowing consistent regulatory governance and oversight. It goes on to say that, in order to realise these benefits, agreement will be required between market participants and global regulators on a number of issues, including:
(1) general structure of initial margin calculations;
(2) requirement of initial margin to meet a 99% confidence level of cover over a 10-day horizon;
(3) model validation, supervisory coordination and governance;
(4) use of “Greeks” rather than full revaluations; and
(5) explicit inclusion of collateral haircut calculations within portfolio SIMM calculations.
The paper deals with each of the aforementioned issues in turn, but not before setting out two important background factors - liquidity implications10 and dispute resolution11 - and listing the 9 criteria that a SIMM should satisfy. These are as follows:
(i) non-procyclicality (the calculation of initial margin should not be linked to market levels or volatility but should be recalibrated periodically or at the behest of the global regulatory body);
(ii) ease of replication of initial margin calculations (necessary for effective dispute resolution);
(iii) transparency (again necessary for effective dispute resolution);
(iv) quick to calculate (to facilitate price quotation whenever a new trade is added to the portfolio);
(v) extensible (to facilitate the addition of new risk factors and/or products as required by the industry and regulators);
(vi) predictability (necessary to preserve consistency in pricing and for capital allocation purposes);
(vii) costs (to be reasonable, so as not to preclude access to the non-cleared markets);
(viii) governance (regulators to approve the risk factors within the model and to require periodic recalibration); and
(ix) margin appropriateness (to ensure that the calculation of initial margin does not result in a vast overstatement of risk when performed across a large portfolio and to ensure the recognition of risk factor offsets within the same asset class).
Turning now to the relevant issues:
1. General structure of initial margin calculations
The content of the paper here is mathematical and is concerned with the treatment of risk offsets within defined asset classes in the calculation of initial margin. In this regard, the ISDA proposal for SIMM is seemingly at odds with the BCBS-IOSCO policy framework. The discussion appears to centre on whether the assessment of offsets should only be made by reference to individual transaction types or should transcend individual transaction types looking at the individual risk factors comprised in and common to each. ISDA is consulting with its members accordingly.
2. Requirement of initial margin to meet a 99% confidence level of cover over a 10-day horizon
The significant point made here is that achieving the desired 99% confidence level presents challenges and that it is appropriate, in constructing the model, to focus the risk factor selection on portfolio types typically seen and to ignore specific edge-case and unusual portfolios. The paper notes that the BCBS-IOSCO proposals are intended to reduce systemic risk, not necessarily the risk presented at the single entity level; and that where counterparties are presenting such unusual portfolios, and one has concern for the counterparty’s performance, one may always require a higher initial margin.
3. Model validation, supervisory coordination and governance
The paper notes that it is imperative for regulators to approve in advance what risk factors are to be used in the model or alternatively specify for what reference portfolios the model must assess adequate initial margin; and further to agree on a reference period (that includes a period of stress) for each asset class. ISDA proposes to work with regulators to agree these benchmarks, noting that, without a common choice, a common model is not possible. As already noted, the model must be extensible and preserve transparency in dispute resolution. ISDA proposes that initial choices are agreed for a preliminary year and re-evaluated by regulators annually thereafter.
4. Use of “Greeks” rather than full revaluations
The paper makes the technical point that, in order to ensure quick revaluations for pricing purposes whenever a new trade is added to the portfolio, initial margin is calculated based on the portfolio's "Greeks" - a proxy for a full revaluation.
5. Explicit inclusion of collateral haircut calculations within portfolio SIMM calculations
As noted above, the BCBS-IOSCO proposals allow collateral haircuts to be determined on the basis of a quantitative model and ISDA proposes that the same model be used for both initial margin and for haircuts.
The ISDA SIMM paper concludes with a proposal to develop a standardised model that meets the criteria considered earlier and that, once agreement has been reached on the issues touched upon above, is approved by regulators.
Implications for market participants
Development of a SIMM that can be used by all market participants will have beneficial cost implications and will ensure that entry to the non-cleared market will not be limited. It will also significantly lower the liquidity impact of the BCBS-IOSCO proposals. Availability of quality collateral will, however, still be an issue.
The BCBS-IOSCO proposals themselves will have several consequences, including:
(i) the calculation of the amount of initial margin to be posted on a group-wide basis, taking account of the €50 million threshold, will require engineering at the level of trade confirmations and CSAs. This may even necessitate some kind of framework document between all relevant parties. ISDA's standard modification to CSAs to eliminate offset of independent amounts may also be employed to ensure that initial margin is posted gross as opposed to net.
(ii) resolution procedures at the level of CSAs may need revisiting to ensure that disputes over independent amounts can be quickly resolved, by reference to model as necessary.
(iii) CSAs and framework agreements will need to reflect the conditions on re-hypothecation considered at footnote 7.
(iv) custodian agreements will need to be put in place to the extent that custodians are used to hold initial margin. It is worth mentioning that, in relation to the New York law CSA, ISDA has already published a number of pro-formas dealing with the segregation of independent amounts where custodians are involved.
ISDA's proposed SIMM is just that - a proposal. It will need refinement and agreement between regulators and industry before it can be translated into a working model in good time for 1 December 2015 (being the effective date for the exchange of initial and variation margin). In the meantime, there is work to be done in the documentation arena - something that ISDA may or may not have on its radar.
3. A maximum €50 million threshold, on a consolidated group basis, may apply to initial margin (compared to zero for variation margin – which must be exchanged on a regular e.g. daily basis. If variation margin is exchanged less frequently than daily, this will increase the amount of initial margin required). All margin transfers may be subject to a de-minimis transfer amount not to exceed €500,000.
4. Initial margin protects the transacting parties from the potential future exposure that could arise from changes in the mark-to-market value of the contract during the time it takes to close out and replace the position in the event that one or both of the counterparties defaults. When provided on a portfolio basis, initial margin will change over time as transactions are added to or removed from the portfolio. Variation margin protects the transacting parties from changes in the mark-to-market that have already happened. It will change on a daily basis.
5. The guidelines endorse the use by parties of both quantitative portfolio margin models (approved in all relevant jurisdictions, subject to ongoing validation and providing a 99% confidence level of cover over a 10-day horizon) and standardised margin schedules (one is provided at Appendix A to the guidelines) for the purposes of calculating initial margin. Initial margin models may account for risk on a portfolio basis provided that the underlying derivatives are subject to a single legally enforceable netting agreement and provided further that risk offsets reliably quantifiable by the model are limited to offsets within well-defined asset classes and not across such asset classes. Counterparties may not switch between model- and schedule-based margin calculations in an effort to ‘cherry-pick’ the most favourable initial margin terms but may, on a consistent basis only, use a model for certain asset classes and a schedule for certain others. To mitigate procyclicality impacts, large discrete calls for additional initial margin due to “cliff-edge” triggers are discouraged. No initial margin will be required from a counterparty that has fully performed under a given transaction e.g. a premium payer under a fully-paid option. In relation to the calculation of both initial margin and variation margin, transacting parties are required to have robust dispute resolution procedures in place.
6. In addition to having good liquidity, eligible collateral (e.g. cash, high-quality government and central bank securities, high quality corporate bonds, high-quality covered bonds, equities included in major stock indices and gold) should not be exposed to excessive credit, market or FX risk and should be reasonably diversified. In addition, it should not exhibit a significant correlation with the creditworthiness of the counterparty (so own-issue securities would be ineligible) or with the value of the underlying portfolio. Haircuts should be applied on a conservative basis to avoid procyclicality and, as with the calculation of initial margin, may be determined on the basis of a quantitative model or a standard schedule (one is provided at Appendix B to the guidelines). ‘Cherry-picking’ is again to be avoided. Substitution is permitted and dispute resolution procedures should additionally be in place to govern disputes as to the value of eligible collateral.
7. The guidelines advocate the use of third party custodians as the most robust means of protecting posted margin and note that collateral arrangements should be effective under all relevant laws and supported by periodically updated legal opinions. Variation margin may be re-hypothecated. Initial margin may only be re-hypothecated if received from a “buy-side” financial firm or non-financial entity and if used only for the purpose of hedging the initial margin collector’s derivatives positions arising out of transactions for which the initial margin was collected. Controls must be in place to ensure a one-time only re-hypothecation and collected collateral must be segregated from the initial margin collector’s proprietary assets. Various other conditions to re-hypothecation apply.
9. The requirement to exchange variation margin will become effective on 1 December 2015 and will apply only to new contracts entered into after that date. The requirement to exchange initial margin (subject to a group-wide threshold of up to €50 million) will be phased in over a five year period beginning 1 December 2015 and will apply initially to covered entities that are party to group-wide transactions having an aggregate month-end average notional amount for June, July and August of that year in excess of €3 trillion, decreasing annually over the five year term to €8 billion; and as with variation margin will apply only to new contracts entered into during the relevant years.
10. The paper notes that in February 2013 BCBS-IOSCO reported a market impact of €0.7 trillion based on a €50 million threshold and a model-based derivation of initial margins; and that ISDA estimates a market impact of over €8 trillion (of which over €4 trillion would be demanded of the major dealers) based on a €50 million threshold and a schedule-based derivation of initial margins. The conclusion reached is that a model-based derivation is feasible but that a schedule-based derivation is not – hence the development of a SIMM.
11. The paper notes that, in order to keep disputes to a minimum, initial margin collectors and collateral posters should have access to the same initial margin model – hence again the development of a SIMM.