The global, economic tsunami caused by the COVID-19 pandemic is, among other things, spurring questions about the best way firms can calculate initial margin (IM), given the recent onset of wildly volatile financial markets.
As you will recall, IM is essential for firms that engage in derivative transactions that are not centrally cleared. Firms are required to comply with the IM rules set by global regulators, particularly as they gear up to meet the regulatory reforms known as the Uncleared Margin Rules (UMR) for non-centrally cleared derivatives. (By the way, regulators recently re-set the UMR/IM deadlines: https://bit.ly/2xVOCjb also because of the pandemic.)
To figure out the right IM levels for most scenarios, many firms turn to the Standard Initial Margin Model (SIMM), a methodology created and sponsored by the International Swaps and Derivatives Association (ISDA). SIMM is also overseen by framework of interested industry participants.
The pandemic-driven volatility has now caused industry participants to question the performance of the SIMM methodology. In response, Scott O’Malia, CEO of ISDA, addresses these concerns via a posting, “Coronavirus and the SIMM,” running in ISDA’s derivatiViews, dated April 8.
Essentially, O’Malia says that the SIMM system is working as it should.
“The SIMM itself is designed to be conservative — it is calibrated based on the past three years of historical data and one year of market stress, currently identified as the 2008/09 financial crisis,” O’Malia says.
“That level of conservatism was intended to avoid the risk of the model being pro-cyclical — in other words, to ensure margin requirements don’t suddenly hike during a period of stress, heaping pressure on market participants. Instead, the inherent conservatism means there is a safety buffer built in to ensure stability even during periods of volatility,” O’Malia adds.
Yet the SIMM way is flexible, O’Malia says.
“That doesn’t mean the SIMM is unalterable. The next quarterly monitoring period will cover the March 2020 market moves, and will provide important data to assess the situation. Any breaches will be brought to the attention of the governance forum, the governance executive committee and the ISDA board in order to determine whether a response is necessary, and the findings will be shared with regulators,” O’Malia says. “If there are isolated breaches, the governance framework allows parties to remediate on a bilateral basis.”
The entire SIMM process “is driven by data and evidence, and this has resulted in a number of adaptations to the model over time,” O’Malia argues. “We stand ready to take the appropriate and necessary steps as shown by the ongoing testing data. As per usual, any changes would be reviewed and approved by regulators across the globe.”
O’Malia underscores that “there is a process in place to monitor the performance of the SIMM, overseen by a governance executive committee with feedback from a governance forum comprising users of the model. Regulators around the world regularly receive details on SIMM performance to validate the soundness of the model.”
The framework supporting SIMM “continues to be appropriate and risk-based. If there is evidence of breaches across the industry, then appropriate action will be taken in consultation with market participants and regulators, based on what the data shows,” O’Malia says.
As volatile markets and the pandemic move into new phases, ISDA, market participants and regulators are going to keep a close eye on how the SIMM methodology is holding up, O’Malia says.
O’Malia’s remarks in full can be found here: https://bit.ly/34xsRmc