Read the Letter Here

  • Source: bankofengland.co.uk

Treliant Takeaway:

Treliant can help conduct a review of the initial margin models for both cleared and uncleared products and help obtain supervisory approvals of internal models. Treliant can help design and implement a remediation and controls assessment framework of the margin models and carry out a thorough review of front to back operating collateral / margin operating model including identifying, testing, and remediating issues around modellable and non-modellable risks.

Highlights:

In light of the Russia-Ukraine crisis and its effect on the commodities market and the recent Archegos crisis, Bank of England (BoE) Prudential Regulation Authority (PRA) is carrying out a review of the adequacy of the margining frameworks covering both cleared and OTC derivatives.

As the last phase of OTC margin reforms is scheduled to go-live in September 2022, PRA has published its conclusions post its review of the SIMM (Standardised Initial Margin Methodology) and raised concerns around 2 specific areas with particular focus around in-scope firms are adequately margined on an individual portfolio basis:

  1. SIMM model governance – PRA has identified number of limitations with 3+1 back-testing as it relates to usage of in-sample data and lack of accountability for non-modelled risk factors in the testing process. PRA notes that 3+1 back-testing is not adequate for poorly-performing models and the resulting initial margin (IM) is not sufficient to cover the risks at 99% confidence level.
  2. Firm’s ability to identify and remediate model underperformance on a timely basis – PRA notes that for firms with unique portfolio of trades and risks purely relying on global ISDA governance process for updating SIMM or negotiating add-ons is not adequate.

PRA notes that some portfolios will risk being systematically under-margined and expects to see the banks take action and report the self assessment findings by December 2022 in order to demonstrate the evidence that under-margining risk is properly addressed by the firms:

  1. Undertake self assessment of their implementation of margining of their OTC derivative portfolios
  2. Provide a corrective action plan for self identified gaps

At the risk of over-simplifying, regulators tend to pay attention to the following issues while reviewing the IM model supervisory approval submissions.

  1. General structure of initial margin calculations;
  2. Requirement of initial margin to meet a 99% confidence level of cover over a 10-day horizon;
  3. Model validation, supervisory coordination and governance;
  4. Use of “Greeks” rather than full revaluations; and
  5. Explicit inclusion of collateral haircut calculations within portfolio SIMM calculations.

As the firms work towards implementing the initial margin models, it is worth addressing the following aspects while seeking supervisory approvals on their IM model implementation.

  1. Non-procyclicality (the calculation of initial margin should not be linked to market levels or volatility but should be recalibrated periodically or at the behest of the global regulatory body);
  2. Ease of replication of initial margin calculations (necessary for effective dispute resolution);
  3. Transparency (again necessary for effective dispute resolution);
  4. Quick to calculate (to facilitate price quotation whenever a new trade is added to the portfolio);
  5. Extensible (to facilitate the addition of new risk factors and/or products as required by the industry and regulators);
  6. Predictability (necessary to preserve consistency in pricing and for capital allocation purposes);
  7. Costs (to be reasonable, so as not to preclude access to the non-cleared markets);
  8. Governance (regulators to approve the risk factors within the model and to require periodic recalibration); and
  9. Margin appropriateness (to ensure that the calculation of initial margin does not result in a vast overstatement of risk when performed across a large portfolio and to ensure the recognition of risk factor offsets within the same asset class).

Author

Kishore Ramakrishnan

Kishore Ramakrishnan is Managing Director, Regulatory Change Management for Treliant’s Capital Markets practice. He has over 20 years of global industry and consulting experience across the banking, capital markets, asset, and wealth management businesses. Kishore is a trusted advisor and respected thought leader in the risk, regulation, and compliance domains…