BY RICHARD THACKRAY

Since the 2008 Financial Crisis, regulators, governing bodies and firms have been implementing changes to eliminate the possibility of another large scale catastrophe. Financial institutions have already invested huge amounts in new systems and process reviews; however the upcoming margin regulation change may have the largest impact of any regulatory changes to date, particularly for collateral departments.

Purpose

The purpose of this specific regulation is to mitigate systematic risk and create a global collateral margining framework which will lead to greater transparency and less disputes, by introducing daily initial margin calls (IM), in addition to existing variation margin calls (VM).

ISDAs SIMM Model

In order to facilitate these new changes, ISDA has created a Standard Initial Margin Model (SIMM) to enable the standardization of calculations, which can be used by market participants globally. It considers the below factors:

  • General structure of margin calculation
  • The IM meets a 99% confidence level based on a 10 day margin risk period
  • Model valuation, supervisory co-ordination and governance
  • Makes use of standard portfolio risk sensitivities (the Greeks) rather than full revaluations
  • Inclusion of collateral haircut calculations within the model.

There is great difficulty in agreeing pricing models, not so much for vanilla products but more so when considering exotic derivatives. As new exotic products are created and become eligible for collateralisation, pricing standardization is essential to reduce the number of disputes, adopting the use of the Greeks will play an important role here. VM is calculated by daily valuation changes which are clearly visible, whereas IM calculations can differ based on the assumptions and choice of model used; which supports the case for ISDA’s SIMM model.

Implementation

Initial Margin will be phased in gradually over the next couple of years on all collateral agreements, based on the Aggregate Month End Average Notional Amount (AMEANA) of a party. Institutions with an AMEANA in excess of the EUR 3 Trillion threshold will be the first subjects of the new IM regulations starting from 1st September 2016. This date has already been prolonged as firms have been working tirelessly to adapt their procedures and documentation to align to the new rules.

ISDA worked closely with the Basel Committee on Banking Supervision (BCBS) and the International Organization of Securities Commissions (IOSCO) to create the new framework for non-cleared OTC derivatives. Documentation releases and conferences have been used to allow all parties to adhere to these changes as efficiently as possible but despite ISDA’s best efforts, there is still no certainty over what will happen on the respective go-live dates.

Challenges for the Banks

Given that many institutions have thousands of collateral agreements, amending the documentation was always going to be one of the biggest challenges. The individual amendment of each agreement would be a near impossible task and by the time this is done, further regulation would be likely to come into play. To relieve legal teams across the globe from having to do this, ISDA created the 2016 Variation Margin Protocol to enable counterparties to quickly put contractual documentation in place with multiple counterparties.

Despite this protocol, there will still be significant costs for banks as they adapt, not least the costs of repapering bilaterally negotiated legal agreements but the largest proportion will be allocated to new IT system investment as current collateral software lacks the capability to cater for the IM calculations. Formerly, only one margin call would be processed per day covering the variation margin amount. In the future there will also be a daily 2 way IM margin call resulting in an increased volume of margin call for collateral teams to issue and then management disputes. To cope with the higher volumes, institutions have had to hire and contract additional resources which will work alongside existing collateral teams in both on and offshore locations.

What Does This Mean for the Market?

Collateral will now be exchanged in a way that is seen to more accurately reflect the risk in portfolios that bilateral counterparties are exposed to, which in turn should reduce the overall risk in the OTC Derivatives market. However, demand for the actual collateral to be posted will increase due to additional IM margin calls, which will result in a squeeze on liquidity as both cash or bonds will become increasingly scarce and expensive as counterparties lock them up to cover the margin requirements. In addition the market will need to invest and support revolutionary change in the Margin and Collateral management function which to date is the last bastion of the post trade to support environment to go through fundamental change.

References:

International Swaps and Derivatives Association (2016). ISDA WGMR Implementation Initiative

OpenGamma (2015). SIMM: An Hvar Approach Implementation

New York Institute of Finance, Hurley, McCabe (2016). ISDA: Standard Initial Margin for Non-Cleared Derivatives

Basel Committee on Banking Supervision, Board of the International Organization of Securities Commissions (2015). Margin requirements for non-centrally cleared derivatives

Ernst & Young LLP (2014). Margin for non-cleared OTC derivatives, Navigating an uncertain regulatory landscape