Are You Prepared for ISDA SIMM?
A Look at September 2020’s Regulations
One of the many areas of focus by regulators in the aftermath of the 2008 financial crisis was a deep and comprehensive review of the risks posed by the widespread use of financial derivative products.
At a meeting of the G20 Leaders in Pittsburgh in 2009, a consensus emerged that,
“All standardized OTC derivative contracts should be traded on exchanges or electronic trading platforms, where appropriate, and cleared through central counterparties by end-2012 at the latest. OTC derivative contracts should be reported to trade repositories. Non-centrally cleared contracts should be subject to higher capital requirements.”
Following this declaration, regulators initially required the mandatory clearing of standardized derivatives. Next, they required counterparties to establish bilateral margining arrangements and strengthen the operational risk procedures for non-centrally cleared OTC derivatives. In the U.S., the rules have been set by the CFTC, and in Europe, the rules are being set by ESMA, the EBA, and EIOPA.
The Final Phases of ISDA SIMM
While central clearing of commodity derivative products (generally via electronic exchanges) has increased, OTC derivatives trading has continued. It’s these trades that have been the subject of more recent new regulations intended to both mitigate credit risk and limit default events.
The International Swaps and Derivatives Association (ISDA) has established a methodology to calculate initial margin (IM) for OTC, non-centrally cleared derivatives called the Standard Initial Margin Model (SIMM). ISDA is implementing the fourth phase of the new SIMM on Sept.1, 2019, and the fifth and final phase on Sept. 1, 2020.
These final phases of the SIMM implementation will be more intense than the previous — increasing the challenges and demands on market participants. In particular, the large number of counterparties falling under these requirements will inevitably create a huge demand for knowledgeable resources and more robust technologies, while simultaneously requiring market participants to complete numerous new contractual agreements in a relatively short amount of time.
What is ISDA SIMM?
In the commodity trading industry, some larger trading firms had previously moved to Credit Support Agreements or Annexes (CSA) as a part of their OTC derivative trading activities. In many instances, the CSA allowed for margining via initial margin and variation margin — along with other agreed terms — in an effort to reduce credit exposure risks between the parties.
However, the difficulty in administrating such agreements (which require constant recalculation of exposure during the term of the agreement) meant that such an approach was sometimes avoided in favor of other risk management techniques. The new regulations are set to enforce this rigorous approach via use of the standardized SIMM methodology which, while helping manage credit exposure associated with non-centrally cleared OTC derivatives, is also clearly designed to encourage greater movement of derivative trading to centralized clearing processes.
At its core, the ISDA SIMM seeks to establish a standard method for calculating initial margins for non-centrally cleared derivatives that minimizes disputes and can be replicated. Rather than focusing on a specific product or transaction, the SIMM is broadly designed to address portfolio risk factors. Though ISDA has proposed alternative netting approaches to meet both U.S. and EU requirements, the calculation is a similar multi-stage process that can be generalized into two major steps — the first decomposes the product or portfolio in risk factors and the second calculates the Initial Margin (IM) requirements. For a detailed view of the entire methodology, please consult the ISDA website.
How Market Participants Will Be Impacted ISDA SIMM
Market participants impacted by this move to the ISDA SIMM will face many challenges, including systems challenges. For traders and institutions that currently use spreadsheets, manual processes, or even automated solutions to manage these instruments and portfolios (including different approaches for different asset classes and commodities), this means that all the impacted trades need to be moved to a centralized location or system for the IM calculation, creating a potentially significant layer of integration complexity.
Of course, the SIMM calculation must also be available in a program or system as well in order to calculate the initial margin. This will need to be integrated into the trade repository and be able to receive periodic updates of the various model factors and assumptions published by ISDA over time. And, once run, the results must then be communicated across other systems and to all impacted parties so that the necessary transactions can take place.
For market participants, meeting these requirements while staying ahead of the competition will require powerful commodity trading and risk management software and advanced analytics to make the most informed trading decisions possible. Ideally, this includes the ability to analyze your trading patterns and current portfolios to anticipate future margin requirements, and then predict cash requirements.
Users of ION Allegro’s advanced commodity analytics can leverage the solution’s capabilities to be better positioned to mitigate ISDA SIMM’s requirements. For example, if your firm normally puts on a series of seasonal trades to mitigate potential extreme price exposures and some portion of those series of trades don’t occur, what could be the impact on margin requirements? Once that impact is determined and paired with your settlements and accounting system, ION Allegro’s solutions can provide an estimate of the impact on corporate cash flows to help ensure your firm will not exceed your reserves and credit lines, in addition to providing a true cost-of-trade metric.
To learn more, download ION Allegro’s corporate brochure in the link below.