The advent of mandatory daily initial margin (IM) and variation margin (VM) requirements for non-cleared over-the-counter (OTC) derivatives transactions has raised many questions regarding the methodology that should be used for computing these margin requirements. Regulatory guidelines require IM levels for non-cleared contracts to cover a 99% loss quantile of the netting set over a horizon of 10 days, as opposed to 3 to 5 days for cleared OTC contracts. We discuss some features of the proposed framework for bilateral margin requirements and advocate an approach that better reflects the actual exposure during closeout in case of the default of a counterparty.
We argue that the liquidation horizon should depend on the size of the position relative to the market depth of the asset. This may be achieved by specifying a minimum liquidation horizon for each asset class associated with an asset-specific size threshold, and scaling the liquidation horizon linearly with position size beyond this threshold. A size-dependent liquidation horizon leads to a liquidity sensitive IM, which penalizes large concentrated positions without requiring any ‘liquidity add-on’.
We also argue that the IM calculation needs to account for the fact that market participants hedge their exposures to the defaulted counterparty once default has been confirmed. As a result, IM should not be based on the exposure of the initial position over the entire liquidation horizon, but on the exposure over the initial period required to set up the hedge, plus the exposure to the hedged position over the remainder of the liquidation horizon.
Based on these observations, we propose a ‘four-step approach’ for the calculation of IM for OTC derivatives transactions. We argue that this approach yields a more realistic assessment of closeout risk for non-cleared transactions.
About the author
Rama CONT is Professor of Mathematics and Chair of Mathematical Finance at Imperial College London and Director of the CFM-Imperial Institute of Quantitative Finance. His research in finance has focused on the modeling of extreme market risks, systemic risk, central clearing and liquidity risk. He has served as consultant and scientific advisor to many CCPs, financial institutions and regulatory bodies in the US, Asia, Europe and Latin America, in particular on issues related to central clearing, systemic risk monitoring and stress testing of CCPs.