Initial Margin Calculation Workflow

Initial Margin requirement is a component of the Unclear Margin Rules originated from the BCBS-IOSCO framework for OTC derivatives. The regulation was set up to reduce systemic risk from OTC derivatives. Initial Margin implementation comes into effect in six phases, with the last two going live on 1st of September 2021 and 1st of September 2022. Firms fall in scope for this requirement depending on their aggregate notional exposure of OTC derivatives, also known as AANA.

Margin requirement on non-centrally cleared derivatives means that counterparties to a trade need to post collateral to mitigate credit risk. Margin requirement comes under the form of Variation Margin as well as Initial Margin. While Variation Margin has a purpose to cover immediate loss, Initial Margin aims to be an extra buffer to cover further loss until close-out. These have become daily requirements as part of the collateral management process of a firm.

Initial Margin (IM) can be calculated using either the industry ISDA SIMM methodology or the standardized Grid or Schedule methodology. While SIMM is a risk-sensitivity based model and takes the risk sensitivities of a portfolio as input to calculate its IM, Grid or Schedule IM is based on a static table of percentages (e.g., 2%, 5%, 15%) to be used as a multiplier to the notional. In scope entities can choose to develop an inhouse margin calculator or select a vendor as the provider for margin calculations.

Under ISDA SIMM calculation method for OTC derivatives based on indices (such as credit default indices, index options or index total return swaps), the look-through approach or alternative approach means that the calculation of risk sensitivities must be performed at the constituent level. The aim of this method is to reduce the final SIMM amount using the diversification effect of the basket. Using the look-through approach in practice can pose challenges both because its calculation is not straightforward to implement and because of the limited market data availability.

As ISDA SIMM is a risk-based model, its effectiveness can only be validated by ongoing systematic backtesting. Backtesting is the generation of a statistical measure of the confidence level a given margin model such as SIMM represents in consideration of current market conditions and current risks held in a portfolio. Validation and performance monitoring using “backtests” need to be conducted on an ongoing basis, normally deemed quarterly, across various jurisdictions globally.