Initial Margin for Non-Centrally Cleared OTC Derivatives ... 15.ISDA has developed a Standard Initial

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  • Initial Margin for Non-Centrally Cleared OTC Derivatives Overview, Modelling and Calibration

    June 2016

    Institute

    Dominic O'Kane Affiliate Professor of Finance, EDHEC Business School

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    Table of Acronyms

    Acronym Meaning

    BCBS Basel Committee on Banking Supervision

    BIS Bank for International Settlements

    CCP Central Counterparties

    CFTC Commodity Futures Trading Commission

    DTCC Depository Trust Company

    DV01 Dollar Change for a 1bp increase in interest rates

    EBA European Banking Authority

    EIOPA European Insurance and Occupational Pensions Authority

    EMIR European Market Infrastructure Regulation

    ESMA European Securities and Markets Authority

    FC Financial Counterparties

    FRTB Fundamental Review of the Trading Book

    GFC Global Financial Crisis of 2007-2009

    IM Initial Margin

    ISDA International Swaps and Derivatives Association

    IOSCO International Organization of Securities Commissions

    MPR Margin Period of Risk

    NFC Non-Financial Counterparties

    OTC Over the counter

    RTS Regulatory Technical Standards

    VM Variation Margin

    WGMR Working Group on Margin Requirements

    I would like to thank Jon Gregory, George Handjinicolauou, Lionel Martellini and David Murphy for their comments. Dominic O'Kane benefited from the support of the French Banking Federation (FBF) Chair on Banking regulation and innovation under the aegis of the Louis Bachelier laboratory in collaboration with the Fondation Institut Europlace de Finance (IEF) and EDHEC.

    The work presented herein is a detailed summary of academic research conducted by EDHEC-Risk Institute. The opinions expressed are those of the authors. EDHEC-Risk Institute declines all reponsibility for any errors or omissions.

  • Dominic O'Kane is a specialist in credit modelling, derivative pricing and risk-management. He spent over 12 years working in the finance industry first at Salomon Brothers and then Lehman Brothers. When he left in 2006 he was head of quantitative research and led the team of over 20 Ph.D. researchers. He has taught at the London Business School and the University of Oxford. He wrote Modelling Single-Name and Multi-name Credit Derivatives (published in 2008 by Wiley Finance) and has contributed to several major industry texts including the Handbook of Fixed Income Securities. He also publishes in international finance journals. He has a doctorate in theoretical physics from the University of Oxford.

    About the Author

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  • Table of Contents

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    Executive Summary ............................................................................................................................... 5

    1. Introduction ...................................................................................................................................... 8

    2. The Non-Cleared OTC Derivatives Market ............................................................................... 12

    3. Margin and Counterparty Risk .................................................................................................... 15

    4. The Regulatory Framework .......................................................................................................... 25

    5. Regulations for Calculating Initial Margin .............................................................................. 31

    6. Calibration of Asset Classes ......................................................................................................... 47

    7. The ISDA Standard Initial Margin Model (SIMM) ................................................................... 56

    8. Discussion ........................................................................................................................................ 61

    References ............................................................................................................................................. 63

    EDHEC-Risk Institute Position Papers and Publications (2009-2012) .................................... 64

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    This report provides a detailed overview and analysis of the forthcoming new framework to be used by large financial institutions to determine initial margin (IM) and variation margin (VM) payments when trading non-cleared over-the-counter (OTC) derivatives. Coming into effect in September 2016, this new framework is based on the recommendations of the BCBS/IOSCO Working Group on Margin Requirements (WGMR)1 which has been set out in [BIS2015].

    This framework has been in development since it was first proposed following the Pittsburgh G20 meeting in 2009. It was a response to the events of September 2008 which saw the bankruptcy of Lehman Brothers, the bailout of AIG and the federal takeover of Fannie Mae and Freddie Mac, all of whom had large exposures to the OTC derivatives market. In the US, the framework has been implemented by the Commodities Futures Trading Commission (CFTC) within the framework of the Dodd- Frank Act Title VII. In Europe the rules will be implemented within the new EMIR directive of the EU.

    Since Pittsburgh, new regulations have accelerated the separation of the OTC derivatives market into a cleared and non- cleared market, with the former focusing on the `standard' OTC derivatives. As of the end of 2013, the size of the non-cleared segment of the interest rate derivatives market alone was approximately $123-$141 trillion.2 The new margining regulations for the non-cleared OTC derivatives are the main subject of this report. Their purpose is to reduce systemic risk across financial markets. In this report we have provided an overview of these new regulations and summarise our observations as follows: 1. The significant growth in the use of central clearing via CCPs has reduced

    the non-cleared market to less standard, more exotic products or products in illiquid currencies. It also means that price discovery is not centralised and trade valuation is model-based. A framework for VM and IM needs to take these factors into account. 2. The role of ISDA3 in creating a standard framework, the ISDA Master Agreement, for trading OTC derivatives, plus inclusion of the close-out netting mechanics, has been key in reducing and simplifying counterparty risk. 3. The new framework will enforce the universal use of variation margin (VM). Although VM has been fairly widely used, especially following the Global Financial Crisis (GFC) of 2007-2009, its use has not been universal. This regulation will mainly impact smaller counterparties as most large counterparties already post VM. 4. The use of collateral for VM is one-way (towards the in-the-money counterparty). Both cash and non-cash collateral can be used, although cash is preferred as it is faster to move. VM collateral can be reused, rehypothecated and does not need to be segregated. This means that the requirement to post VM collateral does not reduce overall market liquidity. 5. Initial Margin (IM) is intended to protect the non-defaulting party to a non-centrally cleared OTC trade from a loss incurred when replacing the trades due to market movements after the other party defaults, including bid-offer increases. The new framework mandates the use of IM for all non-cleared OTC derivatives. Although the concept of IM under the name ̀ independent amount' (IA) had existed previously under ISDA, its usage was not widespread. 6. IM requires a two-way posting of collateral, a change in rules since current market practice has been for one-way (IA). In the event of default, the non- defaulting counterparty keeps enough of

    Executive Summary

    1 - The BCBS is the Basel Committee on Banking Supervision and IOSCO is the International Organization of Securities Commissions. The group responsible for the framework is the Working Group on Margin Requirements (WGMR). 2 - See [ISDA(2014b)]. 3 - The International Swap and Derivatives Association (ISDA) is a trade association for OTC derivatives and their users.

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    the IM collateral posted by the defaulting counterparty to cover any costs involved in replacing its trades. This is the `defaulter pays' principle. It means that the amount of collateral held will exceed the potential loss to the financial system of a single counterparty default. 7. IM margin collateral, which may be cash or non-cash, must be held in such a way that it would provide the non-defaulting counterparty immediate access. The WGMR defines how this collateral is to be segregated and stipulate that it cannot be rehypothecated or reused, except for strictly defined hedging purposes. 8. The first approach for calculating IM is the standard schedule approach. This based on a schedule of `add-ons' - notional weights linked to the type, and maturity of each asset. Based on historical prices, we find that the add-on weights are consistent with a 10-day 99th percentile loss. However the approach is compromised by its treatment of portfolio effects which rely on the net-to-gross ratio (NGR). We examine the NGR and and conclude that it does not capture diversification in the netting set. Nor does this approach take into account the moneyness of options. For this reason we find the standard schedule approach significantly overestimates the IM amount, and is misaligned to the actual risk. We cannot recommend it. 9. The second WGMR approach to calculating IM is based on the use of an internal model where the IM should be the 99th percentile of the