Regulatory Watch: ISDA Offers Standard Margin Model Guidelines

With Basel unyielding on initial margin, the trade group hopes to head off a profusion of logistically intractable models.

The International Swaps and Derivatives Association lost the battle to keep initial margin for OTC derivatives out of Basel III. The next big challenge is ensuring that each market participant doesn’t go its own way in designing a model to calculate initial margin – an outcome that would be a logistical nightmare and make dispute resolution difficult.

If there were a profusion of individual idiosyncratic models in use, each derivatives market participant would have to build the margin models used by each of its counterparties in order to determine whether each counterparty’s margin calls were right. That would be logistically infeasible, ISDA says, and if the models differed in any material way, could lead to significant dispute resolution difficulties.

This wouldn’t be a problem if every market participant used Basel III’s margin schedule, but few, if any, expect to do so. The schedule is expected to be “punitive” and model-based margin calculations are expected to be less onerous.

The Basel Committee requires the models to calculate margin that satisfies a 99% confidence level of cover over a 10-day standard margin period of risk. This leaves a lot of wiggle room. So ISDA issued a report, “Standard Initial Margin Model for Non-Cleared Derivatives” to set some basic parameters.

ISDA’s standard initial margin model (SIMM) rests on a number of common assumptions that market participants and regulators must agree upon:

• General structure of margin calculations
• Requirement for margin to meet a 99% confidence level of cover over a 10-day standard margin period of risk
• Model validation, supervisory coordination and governance
• Use of portfolio risk sensitivities (“Greeks”) rather than full revaluations
• Explicit inclusion of collateral haircut calculations within the portfolio SIMM calculation

ISDA’s SIMM Committee set nine criteria each model must meet:

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 enable 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: Recognizes 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.

Calculations will have to be made quickly, especially in times of market stress, and they will need to be transparent and reproducible. This appears to be a tall order, but with ISDA setting the terms of the discussion and the goals for these models, the industry can take the next step and begin designing them.