ISDA: Standard Initial Margin for Non-Cleared Derivatives

An article by New York Institute of Finance derivatives instructor McCabe Hurley.

ISDA entered the ring for round 2 (or is it round 26?) this week with a proposed Standard Initial Margin Method (SIMM). ISDA has decided to go for standardizing the calculation for initial margin. The proposed Standardized Initial Margin Method (SIMM) was released Monday. Click Here to download ISDA’s proposal for SIMM. In this document, you will find:

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. However, we do have 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 which effects Initial Margin (IM) is inclusion of volatility. Where futures typically collect 3 times the average daily move for IM (and increase IM to adjust for increased volatility), to include changes in market volatility to a 5 or 10 yr 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 the counterparty credit risk should already be priced into the swap by CVA.

The SIMM Calculation must be a standard calculation known and agreed 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 needs to be predictable. Futures margin is predictable, in a bilateral setting ISDA hopes to make the SIMMM calculation predictable or no market player will know how much capital they will need.

Further 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.

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 yr USD swaps and Receiver on 10 yr USD swaps (duration weighted), should not receive 100% offset but both parties should have their SIMM lowered, while adjusting for the correlation between the two maturities.

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