March 8, 2012

European discussion paper on Initial Margin for un-cleared OTC trades

As I discussed in my earlier post, the possibility of posting IM on your not-cleared trades is a biggie. ESMA and other European bodies have published a paper (source page here, PDF here) setting out three options. Risk Magazine also covers it here (subscription required). Anyone who is managing OTC collateral and CSAs now ought to read this and potentially send a response to the questions embedded in the paper. Whilst having to post IM is a big deal – it’s a payday for Lawyers to renegotiate all the existing 171,000+ CSAs in the world, not only to allow for IM, but maybe to upgrade to the new ISDA Standard CSA (SCSA).

The options explained in section IV.2 are:

  1. The posting of IM by all counter parties
  2. The collection of IM by PRFCs only; [PRFC = Prudentially Regulated Financial Counterparty]
  3. PRFCs would not be required to collect IM if the exposure is to certain counterparties and below a certain threshold

So at a minimum large scale users of OTC products will definitely be required to collect IM between themselves, and may get the freedom to only collect IM above a “threshold” from certain parties.

Also this is interesting:

Initial Margin Calculation (not VaR then?)

38. It is important that the methods for calculating IM are transparent and consistent for all counterparties subject to the requirements of Article 6/8 of the Regulation, in order to provide certainty. It is therefore the ESAs‟ view that there should be at least a standardised approach available in order to ensure that all counterparties subject to the requirements will be in a position to calculate their margin requirements.

However, the ESAs also consider the option to allow for the use of appropriate internal models for the calculation of initial margins, subject to further specified minimum requirements.

The methodology for the calculation of initial margins should also take into account the requirements established for CCPs (see ESMA Discussion Paper Draft Technical Standards for the Regulation on OTC Derivatives, CCPs and Trade Repositories) in order to ensure a similar degree of protection and to set the right incentives.

39. For the standardised approach, the ESAs may consider the “Mark-to-market method[See 8 below]” and/or the “Standardised Method[See 9 below]” as set out in the European Capital Requirements Regulation (CRR) as a feasible option.

40. For the internal model, the “Internal Model Method” as set out in the CRR could be the starting point. It should also be considered to what extent internal models under other sectoral legislation may provide a sensible basis for margin calculation models. However, in our view an internal model should only be applicable if it is approved by the competent authority. Internal models have several drawbacks: they may produce lower margin requirements than CCPs thus creating competitive advantages for counterparties with sufficient resources to build them and also disincentivising central clearing.

41. When setting the minimum level of IM requirements and the parameters that need to be considered for the calculation of IM, due respect should be given to macroprudential considerations and possible procyclical effects that these could play.


8 The “Mark-to-market method” is a simple approach for calculating financial derivative exposures where the potential future exposure is calculated by multiplying the notional amount of a contract with a given multiplier (add-on) which is varying according to the product type and the maturity.

9 The “Standardised Method” is a model –based approach for calculating financial derivative exposures which is more risk sensitive than the “Mark-to-market method”.

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