Derivatives - June 08, 2016

Initial Margin for Non-Centrally Cleared OTC Derivatives – Overview, Modelling and Calibration

This paper provides a detailed overview and analysis of the forthcoming new framework to be used by large financial institutions to determine initial margin (IM) and variation margin (VM) payments when trading non-cleared over-the-counter (OTC) derivatives. The Fédération Bancaire Française (FBF) supports the research chair on “Innovations and Regulations in Investment Banking” in which this research was produced.

Coming into effect in September 2016, this new framework was set out in 2015 and is based on the recommendations of the BCBS/IOSCO Working Group on Margin Requirements (WGMR). This framework has been in development since 2009, and was a response to the events of September 2008 which saw the bankruptcy of Lehman Brothers, the bailout of AIG and the federal takeover of Fannie Mae and Freddie Mac, all of whom had large exposures to the OTC derivatives market. The result of these regulations is that banks must hold initial margin collateral. This is intended to protect banks against any close-out loss on the bilateral set of non-cleared OTC derivatives that they would have with a defaulted counterparty.

The paper provides an overview of the new initial margin (IM) regulations that will come into effect in September 2016. Of the two proposed approaches, it explains why the model-based approach is the only framework that correctly captures the counterparty risk presented by non-centrally cleared OTC derivatives. It also sets out the modelling requirements specified by the WGMR, and discusses modelling implementation issues. In particular, the fact that the framework prevents the risk of assets with multiple market factors from being netted fully is discussed. Additionally, it describes the current IM model being developed by the International Swaps and Derivatives Association (ISDA). It then presents some model calibrations across a range of asset classes, performed in a manner that conforms to the WGMR requirements.

This research was supported by the Fédération Bancaire Française (FBF) as part of the research chair at EDHEC-Risk Institute on “Innovations and Regulations in Investment Banking”. This chair is providing advanced research in four areas: skewness as an asset class; corporate and sovereign credit default swap (CDS) markets; the evaluation of policies to regulate financial markets; and options on liquidity.

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