New Paper Explores Credit Exposure in the Presence of Initial Margin
The mandatory daily posting of initial margin (IM) and variation margin (VM) for non-cleared over-the-counter (OTC) derivatives, set by the Basel Committee on Banking Supervision and the International Organization of Securities Commissions (BCBS and IOSCO), has raised many questions in the market. Practitioners and academics are concerned about the practical application of the methodology for computing these margin requirements.
In its final policy for margin requirements for non-centrally cleared derivatives, the BCBS and IOSCO outlined key principles and specifications. These include instruments subject to requirements, the scope of applicability, baseline minimum amounts, methodologies for IM and VM, and eligible collateral for margin.
The BCBS and IOSCO recommend two methods for calculation of IM requirements for non-cleared derivatives: a standard schedule approach (in proportion to the notional size of the contract) and an internal model approach (requiring a quantitative model for the risk factors affecting the positions).
Highlights of the paper
In their new paper Credit Exposure in the Presence of Initial Margin, Alexander Sokol, Chief Executive Officer of technology vendor CompatibL, Leif Andersen, Global Co-head of the quantitative strategies group at Bank of America Merrill Lynch, and Michael Pykhtin, a manager in the quantitative risk team at the Federal Reserve Board in Washington, DC, discuss modeling credit exposure in the presence of dynamic IM and examine the efficiency of IM postings in eliminating counterparty credit risk.
They also explore the calculation of credit valuation adjustment (CVA) under IM full coverage: here, the accuracy of CVA calculations is significantly impacted by exposure spikes. Thus, in the presence of IM, realistic assumptions on the payments both the bank and the counterparty expect to make contingent on counterparty default are essential to capture the impact of trade payments. In addition, Andersen, Pykhtin, and Sokol briefly discuss how to deliver daily exposure without revaluating the portfolio on a daily basis and propose some useful numerical techniques.
How to make it work in practice
As stated above, market players are mostly concerned with the practical application of the methodology for computing the new requirements. In their paper, Sokol, Andersen, and Pykhtin detail the issues and suggest a payment-versus-payment (PvP) approach, such as CLS Bank, as the best way to reduce residual counterparty risk. This requires a simple change in the credit support annex (CSA). In short, it means that the CSA should be amended to set VM based on a two-day portfolio forward value, so the margining is performed ahead of time.
Revised margin requirements framework at a glance
In 2015, the BCBS and IOSCO released a revised framework for margin requirements for non-centrally cleared derivatives. As the market participants expressed their concerns, the launch of the final framework was delayed to 1 September 2016. According to the BCBS and IOSCO, cooperation with market participants will help ensure the new quantitative models for initial margining are consistent with the revised framework, but no further review or approval of such models is expected.