Initial Margin: When Does More Turn Out to Be Less?
Just 36 percent of the initial margin (IM) posted by Lehman Bros at LCH was required to meet replacement and hedging costs of its portfolio. Many believe that the success of LCH in managing the Lehman default has led to both the regulatory push for central clearing and the application of CCP-style margining to the world of bilateral derivatives. Indeed, increasing the amount of collateral held against counterparty credit risk for non-cleared derivative seems consistent with the objective of ensuring the safety of the financial system.
Despite some perceived similarities, there are in fact some stark differences between IM within CCPs and the use of IM for non-cleared OTC derivatives. First in the complexity and liquidity of the products they margin, and second in the processes around which margin calls can be disputed.
Non-cleared derivatives are products that are too complex or too illiquid to clear and risk-manage within a CCP. The same risks that are currently borne by capital on banks’ balance sheets will have to be absorbed by collateral held in a custody account for IM. This means that the risk models that are used to calculate IM must handle many of the same exposures currently treated within banks’ internal capital models.
Banks’ internal capital models, which are based on Value-at-Risk (VaR), have come under significant scrutiny as many modelling assumptions failed and banks were regarded as undercapitalised as a result. An analysis by the BCBS in 2013 found a massive variation between different firms’ calculations on the same portfolio. For example, in a portfolio containing a two-year swaption on a 10-year interest rate swap, the largest VaR was five times greater than the smallest.
Unexpected or erroneous margin calls on OTC derivatives can have serious effects by creating short-term liquidity squeezes, as was seen when AIG received $32 billion in margin calls in Q2 2008. In contrast to clearing, when the margin calculated by the CCP must be paid in order to avoid a default, counterparties that are unwilling or unable to meet margin calls may begin a dispute process. This can be time consuming and occasionally requires third-party intervention to provide independent margin calculations.
Like capital models, IM models are based on a raft of assumptions. The variation of assumptions between firms could lead to an entirely new source of disputes due to the subjectivity of risk models and has led ISDA to spearhead a standardized IM model (SIMM). However, differences can still remain in terms of how firms calculate trade sensitivities or implement the model. Many participants see the need for a third party offering to resolve those differences and minimize disputes.
The challenges of initial margin risk models for non-cleared OTC are just one indication that changing margin regulations are set to have an impact on the OTC derivative market. The number of margin calls is set to increase very significantly, which will be onerous for large and small firms alike. Only time will tell whether the regulations have achieved their objective of reducing systemic risks or whether they have, as some fear, just created other unintended consequences.Paul Jones is Director of Product Management at Markit Analytics and is responsible for the firm's regulatory analytics solutions. He has extensive experience in product strategy, financial engineering and derivatives risk management, and has worked in both market and credit ... View Full Bio