Margin costs leap on Simm rejig and rates hikes

Acadia finds roughly one-third jump in exposure following Simm recalibration, with higher funding costs adding to burden

Acadia
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Initial margin requirements generated by the industry’s standard model jumped by as much as a third when new stress scenarios and higher volatilities were captured in last year’s annual recalibration, according to analysis from margin vendor Acadia. Some say the upwards trend is set to continue in forthcoming updates, posing a headache for hundreds of buy-side firms that may have been hoping to sidestep the requirements.

Analysis of 215 firms caught in the first four waves of initial margin rules found exposures calculated under the standard initial margin model, or Simm, jumped between 17% and 33% in the six weeks before and after the December 2021 model recalibration, averaging 29% across the industry.

Acadia’s co-head of business development, Stuart Smith, says the impact of the Simm recalibration is “clear and substantial,” adding that margin levels have increased for the largest institutional banks “by a significant amount.”

At the same time, the cost of funding higher margin totals has surged on the back of rising benchmark interest rates. Acadia notes that from January to June 2022 the three-month secured overnight financing rate (SOFR) increased by 185 basis points, leaving parts of its client base facing a 90% increase in funding costs. The double whammy means the all-in cost of funding initial margin has risen by more than 150% for some clients, Acadia says.

The rising burden of regulatory IM comes as the sixth and final phase of non-cleared margin rules drags an estimated 775 firms into the regime today (September 1). This requires firms with more than $8 billion in average aggregate notional amounts of bilateral derivatives to exchange initial margin with counterparties.

Rapidly rising margin requirements may make it more difficult for newly in-scope firms planning to duck the rules. Many phase five and six firms are able to avoid posting regulatory IM altogether by relying on margin monitoring to ensure exchange amounts remain below $50 million with each counterparty.

Dipak Chotai, founder of consultancy JD Risk Solutions, says firms on the brink of being pulled into the regime should be preparing to sign the required documentation: “If you’re at $40 million, you’re now going to be sitting there thinking there’s evidence to show this margin requirement can jump quite rapidly.”

Erik Petri, head of triBalance at post-trade vendor Osttra, says firms may find themselves quickly hitting the threshold, forcing them to negotiate new legal documentation and establish custodian accounts – a cumbersome process that can take many months to complete.

“This drives the importance of having sound operational processes in place well ahead of time, since an inability to act quickly may restrict access to trade,” he says.

Overstated?

Developed by the International Swaps and Derivatives Association, Simm has become the preferred model for calculating initial margin on non-cleared over-the-counter derivatives in earlier phases of the rules.

The sensitivities-based model is recalibrated each December using historical risk factor data from banks, exchanges and data vendors. Four years of historical data is required, including one year of stress, to ensure margin amounts calculated by the model cover valuation changes over a 10-day liquidation horizon with a 99% confidence level, as required by the regulation.

The December 2021 recalibration, resulting in Simm 2.4, saw Isda replace a portion of the global financial crisis with a single quarter of Covid-related turbulence to cover the stress period.

Isda believes Acadia’s analysis may overstate the resulting increase in exposures. Analysis by the trade body on a set of constant portfolios shows Simm amounts increased by around 17% as a result of the recalibration.

An Isda spokesperson says there are several factors driving margin exchange amounts, including new trades that are continually executed by in-scope firms, meaning a larger number of transactions are continually caught in rules that apply only to new activity.

“Regulators also require regular recalibration of margin models based on historical data. Given increased market volatility, particularly during the Covid crisis, the margin amounts calculated through these models would be expected to increase,” says the Isda spokesperson.

Acadia’s Smith says Simm exposure amounts may have increased as more transactions were brought into scope of the rules, but believes levels have “predominantly” risen due to recalibration of the Simm methodology and an increase in volatilities.

While the vendor can’t always see the instruments used by clients, it does see the sensitivities of portfolios. Smith’s assumption is that higher commodity and equity volatilities have been key drivers of rising exposures, after a relatively benign three-year period running into 2019: “Bringing 2020 to that calibration, the first year of Covid, [included] a commodity slump when oil prices were negative at one point and an equity crash.”

A market risk manager at a US bank is not surprised by Acadia’s findings. He says the growth in exposure results from a rise in Simm risk weights between version 2.3 and version 2.4, as well as an increase in risk sensitivities for asset classes such as commodities, where sensitivities are measured in percentages rather than basis points.

“A one-year natural gas swap will have a higher Simm delta today than it showed at the end of December last year, hence a higher Simm charge,” says the market risk manager. “It’s a bit less dramatic for asset classes such as interest rates, where the Simm sensitivity is measured in basis points.”

He adds that interest rate volatility contributed to the higher exposures as the measure is used to determine risk weights for add-ons in Simm, such as vega and curvature charges.

More to come

Andy Shaw, managing director of advisory firm Links Risk, warns further increases in Simm exposure are likely. Simm is calibrated annually in December with a one-year lag, meaning volatility resulting from Russia’s invasion of Ukraine will be reflected in the model in two years’ time.

He says the latest numbers expose Simm as an “imprecise model that lags market events by many months.”

Shaw adds that back-testing results for large, diversified portfolios suggest Simm can call for margin three times higher than regulations demand, raising questions over whether more rapid increases may push some users to seek out a more cost-effective model.

“I think we’re potentially at a tipping point now where banks would look into improving the model. I expect banks will ask themselves if there’s an alternative to Simm where they could reasonably cut their margin exposures in half, if not further in some cases.”

Some suggest the recalibration of the Simm could be tweaked to reduce the total period of stress in the backtest.

“I think that there’s been so many stress scenarios that you can’t just keep including them,” says Jo Burnham, risk and margining expert at OpenGamma. “There is a limit on how much of that you can put into a margin-style calculation.”

Regulatory consultant Neil Ryan suggests the different stress periods used in the model could be assigned different weights.

The UK’s Prudential Regulation Authority (PRA), meanwhile, wants banks to run additional Simm backtests and take more timely action to remediate margin shortfalls, warning that for a typical portfolio, Simm might be under-margining risk.

Acadia’s Smith says the impact of the increase in exposure will affect clients to differing degrees; asset managers might have bonds to process as collateral, meaning they may see little impact. An aggressively trading hedge fund, on the other hand, is unlikely to have eligible collateral to hand, and will be looking to post cash.

Andreas Ita, managing partner of consultancy Orbit36, sees a silver lining as higher initial margin amounts should result in lower counterparty credit risk-weighted assets. “The standardised approach for counterparty credit risk takes into account collateral, so higher initial margins can be beneficial,” he says.

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