11 Dec Standard Initial Margin Method (SIMM) Rules – Proposed
Proposed Standardized Initial Margin Method (SIMM) released Monday
ISDA proposed a Standard Initial Margin Method for uncleared derivatives. (Read ISDA’s proposal for SIMM here.) Standardizing Initial Margin for derivatives makes a lot of sense. Each counterparty has to post the same good faith deposit. Managing the difference between counterparties will need to be defined by other variables: maximum swap maturity, amount of contract allowed, etc. ISDA has decided to go for standardizing the calculation for initial margin.
- The general structure of margin calculations
- The initial margin meets the required 99% confidence level over 10 days (10 day VaR)
- Model validation, coordination and governance
- Uses standard portfolio risk sensitivities “Greeks” rather than full revaluations
- Includes explicit standard collateral haircut calculations within the SIMM
The concept of initial margin hasn’t been an issue for bilateral contracts in the past. That said, we do have an extensive history on the futures side of the business. From reading the ISDA document, it looks like they’re working to make the “futures-style” of collecting a good faith deposit and including the large differences between swaps risk (specifically bilateral risk) and cleared futures risk to arrive at a reasonable figure that is not only fair, but possible to post by both counterparties.
One difference that effects Initial Margin (IM) is volatility. Where futures typically collect 3 times the average daily move for IM (and increase IM to adjust for increased volatility), including changes in market volatility to a 5- or 10-year swap could greatly exacerbate the amount of IM posted.
The calculation of IM on a futures contract is easy to replicate from counterparty to counterparty, as the clearinghouse stands in the middle of all trades. In the case of bilateral contracts, the presumption is that the counterparty credit risk should already be priced into the swap by CVA.
The SIMM calculation must be a standard calculation known and agreed to by all market players.
While the SIMM calculation needs to be fast in order to price a large book of swaps, it also needs to be extendible to allow for new risk factors or new products down the road.
The SIMM calculation also needs to be predictable. ISDA hopes to make the SIMM calculation predictable, otherwise no market player will know how much capital they will need. The flexibility will be up to the clearing member to decide how much the client can trade (maximum notional amount and maximum maturity).
In addition to predictability, the costs of implementing SIMM must be reasonable so that the cost of entry doesn’t exclude current liquidity providers and users.
Governance will be of primary importance. Personally, I also think we need unbiased market participants without any “skin in the game” who can review any proposed changes to the SIMM calculation and calibration as necessary.
CORRELATION & OFFSET IN SIMM
Finally, the SIMM calculation should take into account any offsetting positions and calculate the net margin correctly. This will be a balancing act, no doubt. To use a single-yield curve example, a Payer on 5-year USD swaps and Receiver on 10-year USD swaps (duration weighted) should not receive 100% offset, but both parties should have their SIMM lowered – adjusted for the correlation between the two maturities.