1. Margining Requirements for Uncleared Derivatives (BCBS 261, BCBS 317) and ISDA’s Standard Initial Margin Model (SIMM)
Added “(BCBS 261, BCBS 317)”

2. Agenda Background: New Regulation for Margin Requirements
Mechanics of Bilateral Margining
Industry Model for Initial Margin of Uncleared Trades (SIMM)
Practical Examples.
Model Limitations.
Expected Impact of the New Regulation for Uncleared Trades
Implementation challenges

3. Regulatory Requirements for Cleared and Uncleared Trades
As a response to the financial crisis, in 2009 the G20 agreed to measures to reduce counterparty and systemic risk by adopting the following Policy Objectives:
Promoting Central Clearing:
All standardized OTC derivatives contracts should be traded on exchanges or electronic trading platforms by the end of 2012 at the latest, and cleared through CCPs
Non-centrally cleared contracts should be subject to higher capital requirements.
Reduction of Systemic Risk:
Reduce contagion and spillover effects by ensuring that collateral is available to offset the losses caused by the default of a counterparty.
Help market participants better internalise the cost of their risk taking through greater reliance on margins (Variation Margin and Initial Margin).
In 2011, the G20 added margin requirements for uncleared derivatives to the reform program
Initial respose 2009 (from BCBS 317), add “and cleared through CCPs”; added 2011 statement

4. The Role of Variation and Initial Margin
Variation Margin – Covers the potential losses due to the fluctuation in MtM of a position. If a default were to occur, the current exposure of the surviving firm would then be limited and would more likely be covered by the initial margin.
Initial Margin – In the event of a default, the surviving firm could face losses resulting from an increase in replacement costs from the time of default to the time when the positions are unwound or replaced (i.e. the “MPoR”).
Portfolio Value
We should show the replacement period exposure increasing
Potential Exposure collateralized by IM
Current Exposure collateralized by VM
Default
Dispute
Fail
Grace Period
Close Out T
T +10d
Time
Margin Period of Risk

5. The Mechanics of Margining CASE 1: Trade with a CCP
The figure below shows the exchange of cash flows on a given day.
Consider the case where the Bank trades with a Corporate under a CSA and hedges the deal through a CCP. The Bank will exchange Collateral with the Counterparty due to the Variation Margin (dNPV). The Bank can rehypotheticate the Variation Margin to the CCP but not the IM.
Giving that there is no IM received, the Bank must borrow unsecured to fund the IM raising the MVA.
The Bank will also receive remuneration from the CCP only on cash posted.
Bank receives remuneration rate on Posted IM (cash only)
I M t . r IM
Client
Bank
CCP
Bank pays Variation Margin (dNPV) + 𝐼𝑛𝑖𝑡𝑖𝑎𝑙 𝑀𝑎𝑟𝑔𝑖𝑛 𝐼 𝑀 𝑡 +𝐷𝑒𝑓𝑎𝑢𝑙𝑡 𝐹𝑢𝑛𝑑+𝐴𝑑𝑑𝑂𝑛𝑠
Bilateral exchange of Collateral under the CSA Variation Margin (dNPV)
The bank may pass the IM through to the client, or even ask the client for IM plus a buffer
Desk pays IM’s funding rate to its TSY
(𝐼 𝑀 𝑡 . 𝑟 𝑏 )
Treasury

6. The Mechanics of Margining CASE 2: Uncleared Trade
Both parties exchange IM collateral but this cannot be rehypothecated.
The figure below shows the exchange of cash flows on a given day.
Consider the case where the Bank trades with a Corporate under a CSA. The Bank will exchange Variation and Initial Margin with the Counterparty. The Bank can rehypotheticate the Variation Margin but not the IM, which will be posted in a Segregated Account.
The Bank must borrow unsecured to fund the IM giving raise to the MVA.
The Bank will not receive nor pay remuneration on the IM exchanged.
Post IM into a Segregated Account (Client’s custodian)
Client
Bank
Bilateral exchange of Variation Margin (dNPV)
Desk Pays IM funding rate to its TSY
𝐼 𝑀 𝑡 . 𝑟 𝑏
Post IM into a Segregated Account (Bank’s custodian)
Treasury

7. Key Elements of the Margin Requirement Framework
The entities that are affected
The instruments that need to be collateralized
The types of collateral that are permitted
The process of exchanging collateral

8. Bilateral Margin - Implementation Timeline
Variation Margin:
Requirement to collect VM applies from 1st September 2016 for counterparties over the € 3trn level
Applies from 1st March 2017 for all others
Initial Margin:
The requirements to post bilateral IM will be phased over a four year period, according to the size of the institution (“systemically important”), as shown below. The first cohort starting on the 1st September 2016
IM must be collected on gross basis and segregated (without rehypothecation).
Requirements will apply only to new contracts entered into after that date, and between parties that both have a total portfolio in excess of the threshold.
Starting date
Trigger level for consolidated groups
1September 2016
€ 3 Trillion
1September 2017
€ 2.25 Trillion
1September 2018
€ 1.5 Trillion
1September 2019
€ 0.75 Trillion
1September 2020 onwards
€ 8 Billion Trillion
Initial Margin is required where both counterparties belong to consolidated groups having total gross notional values of uncleared OTC derivatives over the trigger level (based on average notional amounts for March, April and May before 1 September of the year in question). IM threshold (exempt) for PFEs below €50million

9. Instruments Exempt of Margining Requirements
Some Foreign Exchange Products
Physically settled FX Swaps and Forwards as well as the physically settled FX transactions associated with the exchange of principal for cross-currency Swaps have been exempted from IM requirements, though they are still subject to VM requirements
Liquidity and short maturity of these instruments were considered
Some Equity Products
Physically settled equity options and forwards are exempt, while other types such as equity indices, single stock, basket options etc are in scope.

10. Eligible Collateral
Assets collected as collateral to cover VM and IM requirements must be liquid so that they can be sold reasonably quickly, if needed, and an appropriate haircut must be applied to reflect the potential decline in market value upon liquidation. Subject to these principles, the margining framework provides a broad, non-exhaustive list of eligible collateral, which includes cash, high-quality government and corporate securities, equities included in major stock indexes, and gold.
IM rehypothecation. Under strict conditions that protect the customer’s rights in the collateral, the margining framework allows a one-time reuse of IM collateral, provided that it is segregated from other assets and is intended only for purposes of hedging a dealer’s derivatives position resulting from transactions with customers. There are no restrictions on the reuse of VM, since the exchange of VM essentially represents the settlement of the current profit or loss on derivatives positions between the parties.
Strict conditions render IM rehypothecation largely impractical to implement

11. ISDA’s Model For Initial Margin (1/4) High level overview
As opposed to capital models, BASEL did not propose an IM model but outlined a set of rules that any IM model has to follow:
Single tail 99% confidence 10-day
3-5 year calibration period, equally weighted
Must include a period of stress
The Industry developed a model to calculate the IM posted and received that is being widely adopted by participants.
The model is based on FRTB’s SBA model with enhancements to comply with the regulatory requirements.
Nested covariance model with limited number of parameters
In essence, the model used a Taylor expansion-like formula to calculate the PnL combined with an Analytical VaR approach to cover the losses at the desired confidence level.
Risk weights, correlations and aggregation methodology is given by the model, thus Banks only have to provide their sensitivities (Delta and Vega: Gamma derived from Vega)

12. ISDA’s Model For Initial Margin (2/4) Regulatory Requirements for the model
The US published the following set of rules for any model seeking approval to be used for IM posting and receiving.
US Rule Requirement
SIMM Model
One-tailed 99% 10-day interval
Calibration and backtesting were both performed with these parameters
Calibration between 3Y and 5Y including a stressed period
Calibration was done over a 4 year period which included a 1Y stress period (chosen separately for each asset class)
Must use all material price risks, including spread and basis risk
Material risk were used (Delta accounts for most of the margin), some non-material risk are excluded. Basis and Spread risk are included
Include material nonlinear characteristics and sensitivity to volatility
Both Vega and Convexity are included in SIMM
No correlation or netting across broad risk categories
No netting or correlation benefit across broad risk categories (called “product classes)
Justification of omissions and approximations
Backtesting was performed
Annual review and recalibration
SIMM Governance plan allows for annual re-calibration and review of SIMM.

13. ISDA’s Model For Initial Margin (3/4) Outline of the model
The model defines a hierarchy of products and risks.
Each trade is assigned into a Product Class (RatesFX, Credit, Equity , Commodity), each of the trade’s Risk Factors are assigned into a Risk Bucket, and into a Risk Class. Netting and diversification is recognized using a correlation structure at each level (except for product class).
For example, a USD Interest Rate Swap would be put into the “RatesFX” Product Class. A major Risk Class for this trade would be “Interest Rate”, and the relevant Risk Bucket, is “USD”, with one Risk Factors being the USD 5y swap rate against 3m Libor.
For example, equity derivatives would have risk in the Interest Rate risk class, as well as the Equity risk class. But all those risks are kept separate from the risks of trades in the RatesFX product class.
Product Class
Risk Class
Risk Bucket
Risk Factor
Risk Class
Risk Bucket
Risk Factor
Interest Rate
Currency
Subcurve/Tenor interest rate
Credit
Sector/quality groupings
Issuer/Seniority/Tenor CDS spread
Equity
Sector/region/size groupings
Equity spot price
Commodity
Sector groupings
Commodity spot price FX
(not used)
FX spot rate (vs base currency)

14. Examples of Product Class Assignment

15. ISDA’s Model For Initial Margin (4/4) Aggregation Rules
Every risk factor is given a risk weight, which represents the 99th percentile of the 10-day moves in that factor, calibrated over a history which includes a stressed period. The weighted sensitivity for bucket b and risk factor k is defined as the raw sensitivity (risk) multiplied by the risk weight for that risk factor:
𝑊 𝑆 𝑏𝑘 =𝑅 𝑊 𝑘 𝑠 𝑏𝑘
Risk factors within the same bucket are correlated together using the standard variance-covariance formula to get the composite risk Kb for the bucket b, using an intra-bucket correlation matrix rkl:
𝐾 𝑏 = 𝑘 𝑊 𝑆 𝑏𝑘 2 + 𝑙≠𝑘 𝜌 𝑘𝑙 𝑊 𝑆 𝑏𝑘 𝑊 𝑆 𝑏𝑙
The risks across the various buckets are also correlated together using a similar formula to get the margin for the risk class overall, using an inter-bucket correlation matrix gbc (simplified version shown):
Margin= 𝑏 𝐾 𝑏 2 + 𝑐≠𝑏 𝛾 𝑏𝑐 𝐾 𝑏 𝐾 𝑐
The main advantages of the nested approach are that it only requires small-sized correlation matrices, which eases operations, makes it easier to keep positive semi-definiteness, and allows reconciliation of calculation between firms because the margin can be cross-checked at the different levels of the hierarchy.
This ignores the concentration (liquidity) risk

16. Potential Implementation Problems
Dispute and Resolution
- Reconciliation of sensitivities (different curves, different volatility models)
- Demand for new D&R resources
Crowdsourcing for the classification of positions – It works when there are many Banks participating on the trading and classification of a position, otherwise, it will be only 2 Banks fighting for the bucket.
IT Development – Specially challenging for small firms.
Calibration of the risk weights and correlations.
Backtesting and exception handling