Initial margin rules set to pose challenges to asset owners
The initial margin rules for non-centrally cleared derivatives are expected to bite institutional investors and asset managers as risk sensitively calculation is not standardised and sophisticated derivatives modelling capability takes a long time to develop.
The global regulation, which begins its latest implementation phase this month, mandates exchange of two-way initial margin so that counterparty risk is minimised as collaterals are available in cases of default. However, the highly technical nature of initial margin calculation poses grave challenges for compliant firms.
“Risk sensitivity calculation is not standardised and there can be material differences between different firms’ calculations,” according to a recent whitepaper published by IHS Markit.
Although the International Swaps and Derivatives Association (ISDA) has standardised part of the initial margin calculation in the standard initial margin model (SIMM), it still leaves the onerous task of computing the risk sensitivities of in-scope positions to the discretion of each firm.
Worse still, a desirable outcome is not guaranteed even though compliant firms outsource this task to a third-party provider, the whitepaper noted.
Initial margin calculation is often left to the most technically minded teams within the organisation due to its complexity, but IHS Markit believed the computation should receive more spotlight.
“Initial margin calculation is not a mere technical issue that should be left simply to the quants who can decipher the initial margin models. It is an issue that warrants the attention of senior management from both an operational and reputational perspective,” according to the whitepaper.
The regulation is part of a reform programme initiated by the G20 in 2009 in the wake of the global financial crisis. Under its first implementation phase in 2016, the rules are applied to entities if their average aggregate notional amount (AANA) of over-the-counter (OTC) derivates breach a specified amount over certain three-month periods. For examples, US entities with AANA of more than $3 trillion are phase 1 firms that should meet the initial margin requirements.
Large global banks and financial firms with relatively big derivative positions are the major compliant firms in the initial phases. But since the AANA threshold is lowered every year, more firms will be subject to the rules in the final phases of five and six, including some asset owners and buy-side firms.
Phase 5 goes live this month while phase 6 will become effective in September 2022. When it is fully implemented, firms with an AANA of above $8 billion will need to comply with the rules. The final phases have been postponed for one year due to Covid-19.
As each instance of risk sensitivity calculation issue may be fundamentally different, the issue can only be systematically resolved by improving the quality and reliability of initial margin calculation - but this is no easy task.
Achieving high-quality, accurate initial margin results requires commitment and investment in derivatives valuation. It takes years of investment to develop comprehensive and sophisticated derivatives modelling capability.
The capability must also include access to high-quality data sets, including hard-to-observe data. But there are very few providers who can cover all aspects, according to the IHS Markit whitepaper.
Even seemingly very simple vanilla trades can cause calculation issues. Mistakes have been commonly made in calculating initial margin amounts where the fine print in the regulatory rules is somewhat subtle. For instance, correct treatment of the resetting principals of mark-to-market (MTM) cross currency swaps is not necessarily straightforward, the report noted.
On the other hand, mismatched initial margin amounts often bring about collateral disputes, which can lead to serious consequences involving external parties.
Frequent occurrence of collateral breaks will also unnecessarily take up valuable resources within the company, as the process of reconciling initial margin disputes is inherently labour intensive and typically requires the involvement of skilled risk management staff.
To understand more about the intricacies of initial margin calculation and how the look-through approach can help optimise initial margin, please download the full whitepaper here.