Since regulatory initial margin (IM) requirements went into effect in 2016, hundreds of derivatives users in scope of the rules have collectively exchanged billions of dollars of IM. Latest figures show the largest 20 market participants had collected more than $280 billion of IM for their non-cleared derivatives transactions at the end of 2021. Virtually all of this has been calculated using the ISDA Standard Initial Margin Model (ISDA SIMM).

The success of the ISDA SIMM is due to several important factors. First, a single global standard is absolutely fundamental to the smooth running of the margin framework. That’s because counterparties ultimately need to agree any margin that needs to be exchanged between them. In the absence of such a standard, it is not hard to imagine the issues created by multiple firms using multiple margin models, all of which would need to be vetted by counterparties and policymakers in individual jurisdictions.

Second, and most importantly, the ISDA SIMM framework is appropriate and fit for purpose. The SIMM remained resilient during the extreme volatility caused by Russia’s invasion of Ukraine, with no widespread and material instances of under margining reported by users. The model was stable and predictable, with the lack of procyclicality thanks to a conservative calibration that incorporates data from stressed periods, including the financial crisis and the pandemic dash for cash.

On September 1 of this year, phase six of the regulatory initial margin (IM) requirements will come into effect, bringing hundreds of new entities into scope. It has been widely expected that the ISDA SIMM would continue to be the standard for IM calculations for this phase, as it has been throughout the first five phases. Counterparties have been planning and preparing for this eventuality. And while we still firmly believe this should be the case, an article in Risk.net today reports that some firms may be discouraged from using the SIMM.

Why?

The issue stems from a letter sent by the UK Prudential Regulation Authority (PRA) to chief risk officers late last month. The letter raises some concerns about the methodology set out under the ISDA SIMM governance framework for assessing model underperformance, arguing that it could lead to some firms holding insufficient amounts of margin in certain circumstances. It calls for UK-regulated institutions to take action to address this by December 2022.

It’s important to note that ISDA conducts regular reviews of the ISDA SIMM methodology and governance, and the methods used to assess model performance have met requirements across regulatory jurisdictions. We also regularly engage with regulators across the globe to exchange feedback on ISDA SIMM performance.

As it stands, the approach for assessing ISDA SIMM performance employs both a one-plus-three back test (based on the most recent three years and one year of stress) and an actual P&L test. The one-plus-three back test acts as the basis for resolving any IM shortfall above a certain threshold, while the actual P&L test provides an additional check for any risks not modelled in the SIMM that are driving material and widespread under margining.

Using an alternative approach – for instance, applying the actual P&L test as the primary basis for bilateral remediation of IM shortfalls – could have significant implications. For one thing, actual P&L is more procyclical than the one-plus-three back test, potentially resulting in unforeseen margin increases during stress events. For another, it can produce out-of-date signals, meaning problems could be flagged that have already been resolved. It’s also operationally much more complex to implement and to reconcile the outputs of the test with a counterparty – a big problem, seeing as the ISDA SIMM was designed to be used by all.

It’s important to stress that the ISDA SIMM has functioned effectively for more than five years, providing a globally consistent standard that creates a level playing field and allows firms to quickly agree the amount of IM that needs to be exchanged, reducing the potential for logjams and messy disputes. It’s by no means certain that alternative approaches would result in the same model performance, stability and operational efficiency. We look forward to working with the PRA to discuss its concerns in order to help ensure a smooth, consistent implementation of the IM requirements for the sixth and final phase, and to avoid any doubt in the minds of phase-six entities that could slow their compliance efforts at this critical time.