ISDA expands on margin practices: Intraday VM, procyclicality, and transparency focus

Rick Steves

The International Swaps and Derivatives Association (ISDA), in collaboration with the Institute of International Finance (IIF), has released a detailed paper providing additional insights into margin practices in derivatives markets.

This paper builds upon their previous response to a consultative paper on margin practices, delving deeper into various complexities and proposing new measures and frameworks for the industry.

In-depth analysis of margin practices

The paper covers several key areas:

  1. Intraday Variation Margin (VM) Collection Practices: ISDA discusses the pros and cons of central counterparties (CCPs) paying out intraday margin. The trade-off between allowing payments in transaction currency versus the potential trapping of liquidity at the CCP is a crucial point of consideration. ISDA suggests scheduled intraday VM calls as they offer predictability in timing. The paper also recommends guidelines for extraordinary VM calls, emphasizing the need for near-real-time transparency and continuous monitoring of intraday exposures.
  2. Measurement of Procyclicality: The association proposes a standardized approach to measure procyclicality, advocating for simplicity and ease of implementation to facilitate comparability between models. This includes disclosing maximum margin increases over specific periods, using a long lookback period, and reporting for various segments like total portfolio and flagship products.
  3. Governance of Anti-Procyclicality (APC) Tools: Highlighting the importance of governance, ISDA recommends a framework for APC tools’ management, including written policies, model transparency, and consistent decision-making processes.
  4. Advance Notice for Margin Rate Increases: The paper considers the feasibility of CCPs providing advance notice of margin rate changes, especially when using Value at Risk (VaR) models. This would aid market participants in preparing for potential funding needs.
  5. Forward-Looking Margin Transparency: ISDA proposes using simple scenarios as a basis for forward-looking margin simulators. This approach aims to estimate potential margin increases and liquidity requirements, providing a clearer outlook for market participants.

Divergence in Views

It’s important to note that many CCPs do not align with the views presented in ISDA’s paper. This divergence highlights the ongoing debate and the need for continued dialogue among various market participants.

As derivatives markets continue to evolve, the ISDA’s paper offers valuable insights and proposals to address the complexities surrounding margin practices.

These suggestions, if adopted, could lead to more predictable and transparent margin requirements, potentially reducing systemic risks in the financial system. However, the differing viewpoints between ISDA and many CCPs indicate that achieving consensus and implementing these changes may be a challenging journey ahead.

Intraday Variation Margin Collection Practices: Balancing Efficiency and Risk
The ISDA’s stance on intraday variation margin (VM) practices brings forth a critical trade-off for Central Counterparties (CCPs). On one hand, paying out intraday VM in transaction currency can prevent liquidity being trapped at the CCP. This approach is particularly viable in markets where local currency payments span the entire trading day and the CCP doesn’t face significant exposures in other currencies. On the other hand, not paying out intraday VM allows for greater flexibility in accepting non-cash collateral or cash in different currencies, albeit at the cost of trapping liquidity.

Scheduled vs. Unscheduled VM Calls
The ISDA underscores the preference for scheduled intraday VM calls due to their predictability. However, in cases where unscheduled calls are necessary, clear guidelines on the conditions and thresholds for such calls are crucial. These guidelines should also encompass whether calls are made across all participants or targeted at specific ones. Moreover, near-real-time transparency about accumulated risk and call thresholds is essential for participants to anticipate the size of intraday VM and/or IM calls.

Measurement of Procyclicality: Striving for Standardization and Transparency
A key aspect of the ISDA’s response is the emphasis on standardized, easy-to-understand measures of procyclicality to ensure comparability between CCPs. They suggest disclosing the maximum margin increase over daily and monthly periods, based on long lookback periods, across various portfolio categories. This transparency, coupled with clear information on the characteristics of anti-procyclicality (APC) tools used by CCPs, can greatly aid market participants in navigating margin fluctuations.

Governance Around APC Tools
Governance considerations for APC tools are highlighted, emphasizing the need for written policies, board sign-offs, consistent decision-making processes, and clear documentation. Transparency regarding the workings of APC tools and model transparency are critical to maintain trust and efficiency in the system.

Forward-Looking Proposals: Margin Rate Increase Notices and Simulators
The ISDA’s response points out the practicality of advance notice for margin rate increases, especially in the context of VaR models. While implementing notice periods in VaR models could be counterintuitive to their up-to-date risk measurement nature, providing early indications of potential margin rate increases could be beneficial. Additionally, the introduction of forward-looking margin simulators could provide a valuable tool for market participants to better prepare for future margin requirements.

The ISDA and IIF’s in-depth analysis and recommendations underscore the need for a more transparent, standardized, and collaborative approach in margin practices. As the financial sector continues to evolve, adapting these practices to the diverse needs of CCPs and market participants will be crucial in maintaining a robust and efficient trading environment. The ongoing dialogue and feedback from various stakeholders, including CCPs, will be essential in shaping a more resilient and transparent margin framework.

Forward-looking margin transparency

ISDA stated: “In the Response, we proposed the following:

“CCPs should share the margin increase (from current levels) if volatility increases and decreases by 10%, 20% or 50% and the impact on their APC tools of these moves. CCPs should provide one-day, one-week and one-month forward view on IM would be under different volatility assumptions. These projections should be provided for:

  • The total portfolio (total margin).
  • flagship products (contract level) – at least the three products with the highest volumes.
  • asset classes if applicable.

Some CCPs claim that such forward-looking estimates how the margin model reacts to volatility shocks is impossible, as the reaction of the margin model is path dependent. We agree that this is the case – a volatility jump of 30% in a week would cause a different margin increase than the same volatility increase over a month.
However, the aim of such forward-looking transparency is not exact numbers, but to have an estimate of potential margin increases and linked liquidity requirements for preparedness of market participants. Such estimates could be provided based on scenarios that are agreed – ideally industry-wide – ex-ante. These scenarios could be based on historical scenarios (credit crisis and the COVID shock) or hypothetical scenarios.
A useful disclosure from a CCP using a VaR model is how much IM would increase (and how much VM would be called) if certain pre-specified stress scenarios were to occur tomorrow and over the next few days (depending on the scenario).”

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