Nov 22, 2019

Getting Ready for the Next Phase of Initial Margin Requirements: The Technology Considerations

Any firm that trades uncleared OTC derivatives knows by now that to be compliant with initial margin (IM) rules for these derivative transactions requires significant changes to trading, trade portfolio management, and collateral management processes. Plenty of information has been provided by the industry on how to manage these operational challenges that arise with IM rules. But for this blog, I want to bring attention to one other very important aspect in terms of meeting the compliance requirements: the technology considerations.

Initial margin rules for uncleared derivative transactions have been progressively phased in since September 2016, with September 2019 representing the fourth phase. Each year, increasing numbers of market participants have become subject to the requirements, but the largest number of firms (according to CME, more than 1000) will be impacted in phases 5 (September 2020) and 6 (September 2021).

The compliance process for IM rules has several dimensions, and one of them is the calculations. The challenges related to implementing a method for making these calculations should not be underestimated. Phase 5 and 6 firms have a few options: they can execute the calculations by their own means, use ISDA’s Standard Initial Margin Model (ISDA SIMM™)—which ISDA introduced as a common methodology to help capital markets institutions calculate initial margin on non-cleared derivatives—or attain access to the SIMM capability from an officially licensed vendor of ISDA SIMM™.

The Technology Requirements and Needs

Whatever option a firm chooses, it will necessitate having technology solutions that are fully aligned with ISDA’s SIMM™ methodology for IM calculations. This can be viewed through three perspectives, including required core capabilities as well as means for reducing IM impact and enhancing performance:

  • Functionality: These are the core capabilities that are required:
    • Generate the sensitivities and aggregations required by SIMM™.
    • Produce initial margin calculations for analysis, as well as produce CRIF (Common Risk Interchange Format) files for counterparty reconciliations and regulator engagement, if needed.
  • Optimization: Firms will want the tools to manage and reduce the IM impact.
    • Be able to anticipate the margin impact of new trades.
    • Apply cheapest-to-trade analytics in order to identify counterparties with the lowest incremental margin for new trades, thus reducing margin costs.
    • Be able to identify risk factors and trades that are driving initial margin numbers.
  • Platform: From a platform perspective, there are powerful benefits to using a single, holistic framework that provides for a unified and comprehensive view of a firm’s derivatives trading business.
    • With such a platform, initial margin calculations are provided alongside derivative. prices, Greeks, XVAs, market risk, counterparty risk, regulatory capital, and other metrics.
    • Will help to reduce/solve disputes with counterparties because firms could quickly and easily identify any and all key mismatches (such as for the computation of initial margin numbers, prices and Greeks) and the drivers of those differences.
    • May reduces total cost of ownership relative to running multiple systems.
    • Efficiencies can be gained with one-system usage.

Market participants that will fall under the scope of initial margin regulations during the next two phases may find themselves embarking on a long and complex journey to get their organization ready, particularly if they choose to implement the rules by their own means. This is why I want to emphasize the benefit of SIMM™. SIMM™ offers a single, standardized model for margin calculations that could help bring a range of benefits, such as enabling greater operational simplicity, permitting a timelier and more transparent dispute resolution between counterparties, and allowing consistent regulatory governance and oversight.

This may be particularly good news for smaller firms, who may have limited resources. For them, partnering with a vendor that can deliver a full-featured initial margin solution may be the best option.

Think Strategically

Based on what has already been experienced in the industry, firms that will be part of phases 5 and 6 will undoubtedly face a learning curve. The first step is to develop a timeline for the project and start planning—it’s best not to wait until the last minute. The other key point I want to emphasize is that by taking a strategic, thoughtful approach to choosing (or building) the right technology solutions and tools, firms could minimize the IM impact and optimize their portfolios to get the best performance possible.

Although I highlighted some of more critical points regarding the technology considerations to support initial margin calculation, there are other technological and operational competencies that will be needed. For more complete information, please contact: sales@numerix.com.

About the Author

Augusto Carvalho has been working with derivatives pricing for almost 17 years. Since 2014, he has been working with Numerix as a Solution Specialist focusing on Market and Credit Counterparty Risk for Latam and, more recently, in Southeast USA. Prior to Numerix, his experience includes modeling credit derivatives for an investment bank in Milan, credit risk management for a pioneer mobile payment startup, and pricing and R&D at the derivatives exchange in Brazil. He holds a masters in theoretical physics and complex systems and applications to risk management and has extensive lecturing experience on derivatives pricing in universities and financial education centers in Brazil.

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