What must you know about Initial Margin Model Governance?

The rules surrounding Initial Margin (IM) model governance are potentially changing as new regulations on model validation, and governance is delayed. However, newly in-scope firms to Uncleared Margin Rules (UMR) must be still preparing and ensuring their processes are in line with governance frameworks

There are several key things firms should know before choosing their IM model as well as information that is vital for implementing and maintaining these. At Margin Reform, we can help firms understand their IM model responsibilities and ensure they are ready for any changes.?

Initial Margin models?

Let’s first understand the two IM model methods universally used to calculate daily posting of IM, the Regulatory Schedule Grid published in the relevant uncleared margin rules by global regulators, and an approved internal model called ISDA SIMM (Standard Initial Margin Model).?

Regulatory Schedule Grid is an IM calculation method which uses a more straightforward process that is less risk-sensitive than ISDA SIMM. The technique works by looking upon a grid of percentages and applies these by choosing the right notional by product type and tenor.?

This method can be used without a third party and works well for market participants who do not want to develop a quantitative model and don’t trade many offsetting risk trades in the same portfolio.?

However, with a growing number of regulatory directives to comply with, most financial institutions have chosen the ISDA SIMM. This model was launched in 2016 and used by all firms impacted by UMR phases 1 to 4.?

UMR phase 1 firms worked under the ISDA umbrella to create the ISDA SIMM as a response to the BCBS IOSCO framework on UMR and to make the process of calculating IM easier. ISDA created a standardised methodology which has been adopted by most banks affected by the new rules. By using a simple collaborative version of a VaR (Value at Risk) model, this allows for consistent methodology between counterparties, reduces implementation challenges and ongoing maintenance costs.?

There were nine areas the ISDA SIMM Committee decided the model would need to satisfy. These are:

1. Non-procyclicality
2. Ease of replication
3. Transparency:
4. Quick to calculate
5. Extensible
6. Predictability
7. Costs
8. Governance
9. Margin appropriateness

The model was created in line with BCBS/IOSCO margin requirements meaning the method enables the IM calculation to cover a margin requirement to a 99% degree of confidence over a 10-day Margin Period of Risk (MPOR).?

How ISDA SIMM works and the key challenges?

The sensitivity-based approach of the model means that the calculation is carried out in two steps. Step one is to calculate the risk sensitivities trade by trade, then step two is to calculate the IM by feeding the sensitivities into the SIMM calculator (internal or external vendor system). Here is a high-level diagram to show the inputs and outputs required to calculate IM amounts.

Despite the steps sounding relatively straightforward, there are a number of challenges associated with implementing IM models for UMR. These include calculating the risk sensitivities which need to be done following the exact ISDA SIMM specifications with the results packaged using the CRIF (Common Risk Interchange Format) files.?

There are also issues relating to performance and scalability. For example, there may be a need for efficient analytics and parallel computing if a firm has a large or growing portfolio size. In addition, it can be difficult to source market data and reference data to put into the IM model, and there can be additional unforeseen problems such as backtesting and IM reconciliation of sensitivities.?

When ISDA SIMM is used, it is vital that a license with ISDA is signed and both the party and the vendor stay up-to-date with the latest version of the model as per global regulatory requirements. It is therefore essential to consider the budget and plan for ongoing maintenance and performance monitoring for ISDA SIMM.?

Model Governance Roles and Responsibilities?

Now that we understand the two models used in UMR, let’s review Model Governance. The global regulators expect to see key model tasks and roles performed by different functional areas with clear segregation of duties. The key roles should be agreed and documented in new risk management procedures:?

Model Owner

Usually, someone in Risk who’s job is to maintain the model and ensure clarity on how it should operate.?

Model Developer

Responsibility to perform on-going model performance reviews and report on the maintenance of the ISDA SIMM methodology.?

Model Implementer?

To implement the model based on the specifications and parameters provided. They provide the Model Owner and the Model Developer with the transparency and tracing of all ISDA tests.?

Model User

Responsible for using the IM numbers to process margin calls and reconcile disputes. Normally someone in Operations.

Model Validator

Their responsibility is to perform an ongoing assessment of the ISDA SIMM suitability. They will also deal with any issues raised by the Model Developer if further review is needed, and should retain their independence from model development and implementation.?

IM Model Assessment Committee?

The internal senior management team will act as the assessment committee. Their role is to approve the suitability of ISDA SIMM or Regulatory Schedule Grid to the portfolio and approve any future enhancements to the model before it is implemented.?

EMIR Refit impact

In the EU, new EMIR changes came into effect last year and brought with it changes regarding UMR Initial Margin model validation. The Regulatory Technical Standards (RTS) will look to relax certain requirements on model validation and governance has been delayed further until H1 2021.??

The result of this is that phase 5 firms will need to continue with their Initial Margin Model Governance implementation (ISDA SIMM & Regulatory Schedule Grid), and ensure that they are meeting IM model governance standards, despite the delay to the RTS.??

IM Model Governance?

At Margin Reform, we offer an Initial Margin Model evaluation to help firms appraise their current status, and where they may need to better prepare or enrich their existing governance approach.

The work is carried out via video conferencing and calls. The evaluation covers an in-depth analysis of the current state of the firms IM models and offers detailed training on roles and responsibilities, policy and procedure support and mitigation planning.?

If you think your firm could benefit from our evaluation above, why not book a free strategy call with our team of expert advisors today. Click this link to find a time slot.