Within DNB's Market Risk and CCR Expert Network, I gave a presentation on the Standard Initial Margining Model (SIMM). This model has been developed by the ISDA in order to facilitate market participants into computing the recently imposed bilateral margining requirements for non-centrally cleared OTC derivatives. The presentation elaborates on the regulatory requirements, the mathematical foundations of the SIMM, and provides a calculation example of the initial margin using the SIMM.

1. Market Risk and Counterparty
Credit Risk Expert Network
23 February 2017

2. About
Zhong Zhi Hu – European Banks Supervision
• Joined DNB in November 2015 with focus on Market Risk, Counterparty
Credit Risk, Liquidity Risk, Interest Rate Risk and Central Clearing
• Nerd at heart
• Fitness junkie and in love with travelling

3. Agenda
• This agenda item have been removed from this
“non-confidential/public” version
• This agenda item have been removed from this
“non-confidential/public” version
• Bilateral Margining and ISDA’s Standard Initial Margining Model
(SIMM)
• Round-table

4. Disclaimer
• Several slides that contain “confidential/non-public” content have
been removed
• Therefore this presentation can be shared. This document is for
educational purposes only

5. Bilateral Margining and ISDA’s
Standard Initial Margining Model
(SIMM)
Zhong Zhi Hu – European Banks Supervision, 23-02-17

6. Financial crisis of 2007-2009
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US Government
Bailout
• Filed for bankruptcy in September 2008
• Many counterparties were protected by the collateral
posted by Lehman under ISDA Master Agreements
• Over 66,000 of Lehman’s OTC derivatives were
cleared at LCH.Clearnet

7. Margining of non-centrally cleared
derivatives (bilateral)
History
2009: G20 seeks to reduce systemic risk in the non-centrally cleared OTC derivatives markets
• all standardized OTC derivatives should be cleared through central counterparties (CCPs) and traded on organized trading
platforms, where appropriate
• non-centrally cleared OTC derivatives should be subject to margin requirements and higher capital requirements
2013-2016: BCBS/IOSCO worked on a framework for margin requirements of non-centrally cleared derivatives
• Imposing two-way initial margin and unilateral exchange of variation margin
• Swaps and physically settled FX forwards are excluded from IM requirements but not from VM requirements
Regulation
• US: under Dodd-Frank Act by the US CFTC
• EU: under European Market Infrastructure Regulation (EMIR)
• Jan 2017: The EC has endorsed the final draft RTS by ESMA/EBA/EIOPA (ESA’s)
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8. Size of non-centrally cleared derivatives
2013Q4: USD 123-141 trn notional amount of non-cleared Interest
Rate Derivatives (IRD). This is ±175% of world GDP (2016)
• 21-25% of total IRD notional amount (USD 600 trn)
• 2015Q2: the notional amount of non-cleared IRD dropped to USD 86 trn
The non-cleared OTC derivatives market is unlikely to disappear
• Some OTC derivatives cannot be centrally cleared due to complexity and illiquidity
of some products. This poses difficulties for CCPs in developing valuation models
for computing margining requirements.
• Firms will always have tailored, bespoke risks they need to hedge
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9. EMIR definition of counterparties
Financial Counterparty
(FC)
- Credit institutions
- Insurers/reinsurers
- Investment firms
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Non-Financial Counterparty
(NFC+)
- Above clearing threshold
Non-Financial Counterparty
(NFC-)
- Below clearing threshold
- Excluded from margining
requirements
• FC and NFC+ are subject to margining requirements
• Central banks and sovereigns are not required to post margins

10. Phase-in period for IM requirements
Phase 1 - March 2017
Initial Margin requirements commence where aggregate month-end notional amount exceeds EUR 3 trillion
• only 12 EU entities meet this threshold
• Variation Margin requirements commence for all counterparties
• VM requirements will mainly impact smaller (financial) counterparties as most large counterparties
already post VM
Phase 2 - September 2017
Initial Margin requirements where aggregate month-end notional amount exceeds EUR 2.25 trillion
Phase 3 - September 2018
Initial Margin requirements where aggregate month-end notional amount exceeds EUR 1.5 trillion
Phase 4 - September 2019
Initial Margin requirements where aggregate month-end notional amount exceeds EUR 0.75 trillion
Phase 5 -September 2020
Initial Margin requirements where aggregate month-end notional amount exceeds EUR 8 billion
End of phase-in.
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11. Margining rules
• EU entities are obliged to collect and post margins to non-EU FC and NFC+
• Intragroup transactions are exempted from bilateral margining requirements if certain conditions
are met
Initial Margining
• No netting of IM between 2 parties, whereas ISDA master agreement allows for bilateral netting
• Concentration limit for IM collateral depending on nature (cash, bonds, equities)
• Strict rules on the segregation and rehypothecation of initial margin collateral
Variation Margining
• Parties are required to exchange VM daily subject to a minimum transfer amount of EUR 500k (EU)
or USD 500k (US)
• VM collateral can be rehypothecated and does not need to be segregated
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12. Margining computation
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Initial margining
• BCBS/IOSCO: IM may be calculated using a standardised margin schedule or an internal models (or a third party model)
• IM models should cover potential future exposure (PFE) at the 99% confidence level over a 10-day horizon
Variation margining
• Based on current exposure and is calculated by the mark-to-market value of derivatives
Standardised initial margin schedule (BCBS/IOSCO)
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13. Fundamentals of ISDA SIMM
ISDA estimates the total IM for the entire market under standardised is USD 10.2 trn vs USD
1.7 trn under internal models
ISDA key requirements for a standard internal model
Similarity with FRTB
• Adopts essentially the same risk factors and models them in a similar way
• SIMM takes into account non-delta risks: vega and curvature sensitivities
• Main difference: IM is based on a 99% VaR while FRTB is based on a 97.5% Expected Shortfall
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• Easy to replicate and transparent
• Quick
• Extensible
• Low cost
• Governance
• Margin appropriateness

14. ISDA SIMM
Four product classes
• Interest rates and FX
• Equities
• Credit Qualifying (investment grade) and non-qualifying
• Commodities
IM amount
• IM per risk class IMrisk class = Deltarisk class + Vegarisk class + Curvaturerisk class
• Curvature and vega only need to be computed for products with optionality and volatility sensitivity respectively
• Netting only within product class: no cross-product class netting
• IM for product class
• r = risk class
• 𝜓 = correlation
• Total IM requirement for institution
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Six risk classes
• Interest rates
• FX
• Equities
• Credit Qualifying
• Credit non-qualifying
• Commodities

15. SIMM Methodology
ISDA SIMM methodology is based on a 2nd order Taylor polynomial
• Use of sensitivities (portfolio greeks) rather than “full reval” method
• Delta-gamma-vega approximation
• 𝛥 𝑉 ≈
𝛿𝑉
𝛿𝑋
∗ 𝛥 𝑋 + ½ ∗
𝛿2 𝑉
𝛿𝑋2 ∗ 𝛥(𝑋)² +
𝛿𝑉
𝛿 𝜎
∗ 𝛥(𝜎)
• Δ(V) ≈ delta*Δ(X) + ½*gamma*Δ(X)² + vega*Δ(σ)
ISDA SIMM: no need to estimate Δ(X) and Δ(σ) that correspond to a 99% PFE
• These are hard to estimate for every traded OTC and form potential margining disputes
• ISDA provides risk weights (RW) and correlations which are calibrated to cover the PFE
at a 10-d horizon at ≥ 99%.
• Only need to compute the sensitivities
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16. SIMM computation
Netting set of two trades
• €20m 3-year payer swap with DV01 of -1500
• €5 m 10-year receiver swap with DV01 of 1200
𝑆𝐼𝑀𝑀𝐼𝑅 & 𝐹𝑋 = 𝐷𝑒𝑙𝑡𝑎𝐼𝑅 & 𝐹𝑋 + 𝐶𝑢𝑟𝑣𝑎𝑡𝑢𝑟𝑒𝐼𝑅 & 𝐹𝑋 + 𝑣𝑒𝑔𝑎𝐼𝑅 & 𝐹𝑋
𝑆𝐼𝑀𝑀𝐼𝑅 = 𝐷𝑒𝑙𝑡𝑎𝐼𝑅 (curvature and vega do not have to be calculated for IR swaps)
• 𝐷𝑒𝑙𝑡𝑎𝐼𝑅 = 𝐷𝑉013𝑌 ∗ 𝑅𝑊3𝑌
2 + (𝐷𝑉0110𝑌∗ 𝑅𝑊10𝑌)2 + 2𝜌3𝑌,10𝑌 𝐷𝑉013𝑌 ∗ 𝑅𝑊3𝑌 ∗ (𝐷𝑉0110𝑌∗ 𝑅𝑊10𝑌)
• 𝑅𝑊3𝑌, 𝑅𝑊10𝑌 and 𝜌3𝑌,10𝑌 can be found from ISDA SIMM tables
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17. SIMM computation
𝐷𝑒𝑙𝑡𝑎𝐼𝑅 = 𝐷𝑉013𝑌 ∗ 𝑅𝑊3𝑌
2 + (𝐷𝑉0110𝑌∗ 𝑅𝑊10𝑌)2 + 2𝜌3𝑌,10𝑌 𝐷𝑉013𝑌 ∗ 𝑅𝑊3𝑌 (𝐷𝑉0110𝑌∗ 𝑅𝑊10𝑌)
• €20m 3-year payer swap with DV01 of -1500
• €5 m 10-year receiver swap with DV01 of 1200
ISDA SIMM risk weights 𝑅𝑊 for IR products of different currencies
• regular volatility currencies: USD, EUR, GBP, CHF, AUD, NZD, CAD, SEK, NOK, DKK, HKD, KRW, SGD, and TWD
• low-volatility currencies: JPY
• high-volatility currencies: all other currencies
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18. SIMM computation
𝐷𝑒𝑙𝑡𝑎𝐼𝑅 = 𝐷𝑉013𝑌 ∗ 𝑅𝑊3𝑌
2 + (𝐷𝑉0110𝑌∗ 𝑅𝑊10𝑌)2 + 2𝜌3𝑌,10𝑌 𝐷𝑉013𝑌 ∗ 𝑅𝑊3𝑌 (𝐷𝑉0110𝑌∗ 𝑅𝑊10𝑌)
• €20m 3-year payer swap with DV01 of -1500
• €5 m 10-year receiver swap with DV01 of 1200
The margining rules allow for netting within product class
• 𝐷𝑒𝑙𝑡𝑎𝐼𝑅 = −1500 ∗ 47 2 + (1200 ∗ 45)2+2 ∗ 0.831 −1500 ∗ 47 (1200 ∗ 45)
• 𝑆𝐼𝑀𝑀𝐼𝑅 = 𝐷𝑒𝑙𝑡𝑎𝐼𝑅=39,484
Under no netting within product-class
• 𝐼𝑀3𝑌 = −1500 ∗ 47 2 = 70,500
• 𝐼𝑀10𝑌 = 1200 ∗ 45 2 = 54,000
• Individual margining amounts are higher due absence of netting benefits
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19. Concerns
• IM impacts market-wide liquidity as the IM collateral cannot be re-
used except in a fairly narrow set of circumstances
• It becomes harder to access the OTC markets, while most market
participants use OTC derivatives to hedge their risks
• Procyclicaclity
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20. Links
• BCBS/IOSCO http://www.bis.org/bcbs/publ/d317.pdf
• ISDA SIMM Methodology http://isda.link/simmmethodology
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