Margining Requirements for Uncleared Derivatives (BCBS 261, BCBS

Margining Requirements for Uncleared Derivatives (BCBS 261, BCBS

Margining Requirements for Uncleared Derivatives (BCBS 261, BCBS 317) and ISDAs Standard Initial Margin Model (SIMM) Agenda Background: New Regulation for Margin Requirements Mechanics of Bilateral Margining Industry Model for Initial Margin of Uncleared Trades (SIMM) Practical Examples. Model Limitations. Expected Impact of the New Regulation for Uncleared Trades Implementation challenges 2 Regulatory Requirements for Cleared and Uncleared Trades As a response to the financial crisis, in 2009 the G20 agreed to measures to reduce counterparty and systemic risk by adopting the following Policy Objectives: Promoting Central Clearing: All standardized OTC derivatives contracts should be traded on exchanges or electronic trading platforms by the end of 2012 at the latest, and cleared through CCPs Non-centrally cleared contracts should be subject to higher capital requirements. Reduction of Systemic Risk: Reduce contagion and spillover effects by ensuring that collateral is available to offset the losses caused by the default of a counterparty. Help market participants better internalise the cost of their risk taking through greater reliance on margins (Variation Margin and Initial Margin). In 2011, the G20 added margin requirements for uncleared derivatives to the reform program 3 The Role of Variation and Initial Margin Variation Margin Covers the potential losses due to the fluctuation in MtM of a position. If a default were to occur, the current exposure of the surviving firm would then be limited and would more likely be covered by the initial margin. Initial Margin In the event of a default, the surviving firm could face losses resulting from an increase in replacement costs from the time of default to the time when the positions are unwound or replaced (i.e. the MPoR).

Portfolio Value Potential Exposure collateralized by IM Current Exposure collateralized by VM T Disput e Default 4 Fail Grace Period Grace Period Close Out Margin Period of Risk T +10d Time The Mechanics of Margining CASE 1: Trade with a CCP The figure below shows the exchange of cash flows on a given day. Consider the case where the Bank trades with a Corporate under a CSA and hedges the deal through a CCP. The Bank will exchange Collateral with the Counterparty due to the Variation Margin (dNPV). The Bank can rehypotheticate the Variation Margin to the CCP but not the IM. Giving that there is no IM received, the Bank must borrow unsecured to fund the IM raising the MVA.

The Bank will also receive remuneration from the CCP only on cash posted. Bank receives remuneration rate on Posted IM (cash only) . Client Bank Bilateral exchange of Collateral under the CSA Variation Margin (dNPV) CCP Bank pays Variation Margin (dNPV) + Desk pays IMs funding rate to its TSY (. Treasury 5 The Mechanics of Margining CASE 2: Uncleared Trade Both parties exchange IM collateral but this cannot be rehypothecated. The figure below shows the exchange of cash flows on a given day. Consider the case where the Bank trades with a Corporate under a CSA. The Bank will exchange Variation and Initial Margin with the Counterparty. The Bank can rehypotheticate the Variation Margin but not the IM, which will be posted in a Segregated Account. The Bank must borrow unsecured to fund the IM giving raise to the MVA. The Bank will not receive nor pay remuneration on the IM exchanged. Post IM into a Segregated Account (Clients custodian)

Bank Client Bilateral exchange of Variation Margin (dNPV) Desk Pays IM funding rate to its TSY . Post IM into a Segregated Account (Banks custodian) 6 Treasury Key Elements of the Margin Requirement Framework The entities that are affected The instruments that need to be collateralized The types of collateral that are permitted The process of exchanging collateral 7 Bilateral Margin - Implementation Timeline Variation Margin: Requirement to collect VM applies from 1st September 2016 for counterparties over the 3trn level Applies from 1st March 2017 for all others Initial Margin: The requirements to post bilateral IM will be phased over a four year period, according to the size of the institution (systemically important), as shown below. The first cohort starting on the 1st September 2016

IM must be collected on gross basis and segregated (without rehypothecation). Requirements will apply only to new contracts entered into after that date, and between parties that both have a total portfolio in excess of the threshold. Starting date Trigger level for consolidated groups 1September 2016 3 Trillion 1September 2017 2.25 Trillion 1September 2018 1.5 Trillion 1September 2019 0.75 Trillion 1September 2020 onwards Initial Margin is required where both counterparties belong to consolidated groups having total gross notional values of uncleared OTC derivatives over the trigger level (based on average notional amounts for March, April and May before 1 September of the year in question). IM threshold (exempt) for PFEs below 50million 8 Billion Trillion 8 Instruments Exempt of Margining Requirements

Some Foreign Exchange Products Physically settled FX Swaps and Forwards as well as the physically settled FX transactions associated with the exchange of principal for cross-currency Swaps have been exempted from IM requirements, though they are still subject to VM requirements Liquidity and short maturity of these instruments were considered Some Equity Products Physically settled equity options and forwards are exempt, while other types such as equity indices, single stock, basket options etc are in scope. 9 Eligible Collateral Assets collected as collateral to cover VM and IM requirements must be liquid so that they can be sold reasonably quickly, if needed, and an appropriate haircut must be applied to reflect the potential decline in market value upon liquidation. Subject to these principles, the margining framework provides a broad, non-exhaustive list of eligible collateral, which includes cash, high-quality government and corporate securities, equities included in major stock indexes, and gold. IM rehypothecation. Under strict conditions that protect the customers rights in the collateral, the margining framework allows a one-time reuse of IM collateral, provided that it is segregated from other assets and is intended only for purposes of hedging a dealers derivatives position resulting from transactions with customers. There are no restrictions on the reuse of VM, since the exchange of VM essentially represents the settlement of the current profit or loss on derivatives positions between the parties. Strict conditions render IM rehypothecation largely impractical to implement 10 ISDAs Model For Initial Margin (1/4) High level overview As opposed to capital models, BASEL did not propose an IM model but outlined a set of rules that any IM model has to follow: Single tail 99% confidence 10-day 3-5 year calibration period, equally weighted Must include a period of stress

The Industry developed a model to calculate the IM posted and received that is being widely adopted by participants. The model is based on FRTBs SBA model with enhancements to comply with the regulatory requirements. Nested covariance model with limited number of parameters In essence, the model used a Taylor expansion-like formula to calculate the PnL combined with an Analytical VaR approach to cover the losses at the desired confidence level. Risk weights, correlations and aggregation methodology is given by the model, thus Banks only have to provide their sensitivities (Delta and Vega: Gamma derived from Vega) 11 ISDAs Model For Initial Margin (2/4) Regulatory Requirements for the model The US published the following set of rules for any model seeking approval to be used for IM posting and receiving. US Rule Requirement SIMM Model One-tailed 99% 10-day interval Calibration and backtesting were both performed with these parameters Calibration between 3Y and 5Y including a stressed period Calibration was done over a 4 year period which included a 1Y stress period (chosen separately for each asset class) Must use all material price risks, including spread and basis risk

Material risk were used (Delta accounts for most of the margin), some non-material risk are excluded. Basis and Spread risk are included Include material nonlinear characteristics and sensitivity to volatility Both Vega and Convexity are included in SIMM No correlation or netting across broad risk categories No netting or correlation benefit across broad risk categories (called product classes) Justification of omissions and approximations Backtesting was performed Annual review and recalibration SIMM Governance plan allows for annual re-calibration and review of SIMM. 12 ISDAs Model For Initial Margin (3/4) Outline of the model The model defines a hierarchy of products and risks. Each trade is assigned into a Product Class (RatesFX, Credit, Equity , Commodity), each of the trades Risk Factors are assigned into a Risk Bucket, and into a Risk Class. Netting and diversification is recognized using a correlation structure at each level (except for product class). For example, a USD Interest Rate Swap would be put into the RatesFX Product Class. A major Risk Class for this trade would be Interest Rate, and the relevant Risk Bucket, is USD, with one Risk Factors being the USD 5y swap rate against 3m Libor.

For example, equity derivatives would have risk in the Interest Rate risk class, as well as the Equity risk class. But all those risks are kept separate from the risks of trades in the RatesFX product class. Product Class Risk Class Risk Bucket Risk Class Risk Bucket Risk Factor Interest Rate Currency Subcurve/Tenor interest rate Credit Sector/quality groupings Issuer/Seniority/Tenor CDS spread Equity Sector/region/size groupings Equity spot price Commodity Sector groupings Commodity spot price FX (not used) 13

FX spot rate (vs base currency) Risk Factor Examples of Product Class Assignment RiskType Risk_FX Risk_FX Risk_FX Risk_FX Risk_FX Risk_FX Risk_FX Risk_FX Qualifier Bucket EUR EUR EUR USD GBP EUR JPY EUR RiskType Risk_CreditQ Risk_CreditQ Risk_CreditQ Risk_CreditQ Risk_CreditQ Risk_CreditQ Risk_CreditQ Risk_CreditQ Risk_CreditQ Risk_CreditQ Risk_CreditQ Qualifier ISIN:BE0934259525 ISIN:BE0934259525 ISIN:CA112585AG91

ISIN:CA112585AG91 ISIN:CA82028KAP62 ISIN:CA82028KAP62 ISIN:FR0000108359 ISIN:FR0000108359 ISIN:CH0010519475 ISIN:UNKNOWN1 ISIN:UNKNOWN2 Bucket RiskType Risk_IRCurve Risk_IRCurve Risk_IRCurve Risk_Inflation Risk_IRCurve Risk_IRCurve Risk_Inflation Risk_IRCurve Risk_IRCurve Risk_IRCurve Risk_IRCurve USD USD USD USD EUR EUR GBP JPY JPY AUD INR Qualifier 2 2 2 2 5 5 7

7 9 Residual Residual Label1 Label2 Amount AmountCurrency 1,000,000 USD -1,000,000 USD -1,500,000 USD 1,500,000 USD 2,000,000 USD -2,000,000 USD -2,300,000 USD 2,300,000 USD AmountUSD ProductClass 1,000,000 RatesFX -1,000,000 RatesFX -1,500,000 Equity 1,500,000 Commodity 2,000,000 Credit -2,000,000 RatesFX -2,300,000 RatesFX 2,300,000 RatesFX Label1 Label2 Amount 10,000 -10,000 20,000 -40,000 -30,000 10,000 5,000 14,000 -10,000

-30,000 30,000 AmountUSD 10,000 -10,000 20,000 -40,000 -30,000 10,000 5,000 14,000 -10,000 -30,000 30,000 1y 5y 2y 2y 1y 2y 2y 5y 1y 10y 2y Bucket Sec Sec 1 10y 1 5y 1 2y Label1 Label2 Libor3m Libor1m OIS 1 10y

1 20y Libor3m Libor3m 2 6m 2 3m 1 10y 3 2y Libor3m Libor3m Libor3m Libor3m 14 AmountCurrency USD USD USD USD USD USD USD USD USD USD USD Amount AmountCurrency 10,000 USD -15,000 USD 5,000 USD -10,000 USD -20,000 USD 5,000 USD 10,000 USD -10,000 USD 10,000 USD 5,000 USD 5,000 USD ProductClass

Equity Equity Credit Credit Credit Credit Credit Credit Credit Equity Credit AmountUSD ProductClass 10,000 Commodity -15,000 Credit 5,000 Credit -10,000 RatesFX -20,000 Equity 5,000 Equity 10,000 RatesFX -10,000 RatesFX 10,000 RatesFX 5,000 RatesFX 5,000 RatesFX ISDAs Model For Initial Margin (4/4) Aggregation Rules Every risk factor is given a risk weight, which represents the 99th percentile of the 10-day moves in that factor, calibrated over a history which includes a stressed period. The weighted sensitivity for bucket b and risk factor k is defined as the raw sensitivity (risk) multiplied by the risk weight for that risk factor: Risk factors within the same bucket are correlated together using the standard variance-covariance formula to get the composite risk Kb for the bucket b, using an intra-bucket correlation matrix rkl: The risks across the various buckets are also correlated together using a similar formula to get the margin for the risk class overall, using an inter-bucket correlation matrix gbc (simplified version shown):

The main advantages of the nested approach are that it only requires small-sized correlation matrices, which eases operations, makes it easier to keep positive semi-definiteness, and allows reconciliation of calculation between firms because the margin can be cross-checked at the different levels of the hierarchy. 15 Potential Implementation Problems Third party logo Dispute and Resolution - Reconciliation of sensitivities (different curves, different volatility models) - Demand for new D&R resources Crowdsourcing for the classification of positions It works when there are many Banks participating on the trading and classification of a position, otherwise, it will be only 2 Banks fighting for the bucket. IT Development Specially challenging for small firms. Calibration of the risk weights and correlations. Backtesting and exception handling 16

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