May 15th, 2018 by Nick Railton-Edwards
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There is mounting pressure to revisit a fundamental aspect of the IM calculation methodology. The BCBS-IOSCO 2015 framework mandates an IM determination based on a 99% VAR over a fixed 10 day liquidation horizon[1]. ISDA have published a paper by Professor Rama Cont, Chair of Mathematical Finance at Imperial College London, which advocates for a more nuanced IM calculation, predicated on the market depth of individual positions and a liquidity horizons that distinguishes time to hedge from the point of liquidation. During interviews at the recent ISDA AGM, the proposal was backed by the CFTC’s Chairman Christopher Giancarlo and Craig Phillips, Counsellor to the Secretary of the US Department of the Treasury. Professor Cont’s report is brief, compelling and accessible, a rare combination in risk management academia and is well worth reading in full. Its salient points are summarised below for reference:

  • Background– The paper outlines the background to the IM regulations and the genesis of the 10 day 99% loss quantile- essentially subjective if not entirely random- Two times the 5 day horizon standard for centrally cleared swap contracts and a commonality with the 10 day minimum risk horizon under the FRTB.
  • If the question is addressed, regulations acknowledge that 10 days represents the upper bound of close-out period estimates.
  • An increase from 5-10 days represents an approximately 40 % increase in margin.
  • Liquidity Horizon Scaling– The actual close-out period for a position is determined by position size relative to market depth in that particular instrument.
  • The liquidity horizon should be scaled proportionally to position size.
  • Distinguish time to hedge from time to liquidate- CCP position liquidation is distinct from OTC. In bilateral transactions, the non-defaulting party typically confirms whether a credit event has occurred, then hedges the exposure using liquid instruments.
  • To reflect market reality, the Margin Period of Risk IM should measure VAR to time to hedge and the VAR of the hedge position.
  • Typical time to hedge is 3 days. This should also be scaled for liquidity.

Professor Cont therefore makes two related points: a fixed liquidity horizon does not account for the liquidity characteristics arising from position size, a 10 day fixed horizon does not reflect actual market practice. In remediation, the proposal advocates a four-step process:

  • Determine appropriate liquidation horizon. Above a minimum, scale horizon for position size.
  • Determine macro hedge for positions in netting set. Use scaled hedging if the hedging instrument(s) exceed a set liquidity threshold.
  • Compute 99% loss quantile to hedging horizon.
  • Compute 99% loss quantile of basis risk from hedging horizon to liquidation horizon.

Total liquidity-scaled IM is then determined by adding the two calculations together.

In purely conceptual terms, the report is difficult to argue against, the current “one size fits all trades” IM liquidity horizon clearly lacks any degree of nuance and does not reflect actual market hedging practice. It is unlikely that a more accurate calculation will adversely impact total systemic risk and by virtue of reducing margin requirements may be less likely to trigger unintended liquidity shortages. The proposed change will only require amendments in exceptional cases, the majority of IM documentation simply refers to the latest applicable SIMM. Required operational changes are likely to be more significant. Although there are no timelines for its adoption, the proposal already has the tacit support of major regulators and trade bodies and an estimated 40 increase decrease in IM margin will be met with deafening roars of approval from market participants.



[1] Although the period of historical data used and the mandatory inclusion of stressed data varies from one jurisdiction to another, the application of 99% confidence over a 10 day horizon is universal to date.

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