The International Swaps and Derivatives Association (ISDA) has published a new academic paper that analyses the regulatory initial margin framework for the non-cleared derivatives market and argues that the 10-day liquidity horizon applied under the framework is “not realistic”.
The paper, written by Rama Cont, chair of mathematical finance at Imperial College London, examines the rationale for the 10-day liquidity horizon applied under the initial margin rules for non-cleared trades, and assesses whether it is appropriate. The 10-day period is double the five days set for cleared trades.
The research argues that using a fixed liquidation horizon of 10 days is unrealistic because it does not take the liquidity characteristics of the assets or the size of the position into account. Instead, the paper recommends that the liquidation horizon should depend on the size of the position relative to the market depth of the asset.
It also argues that instant margin calculation needs to account for the fact that market participants hedge their exposures to the defaulted counterparty once default has been confirmed. Therefore, it suggests, it should not be based on the exposure of the initial position over the entire liquidation horizon, but on the exposure over the initial period required to set up the hedge, plus the exposure to the hedged position over the remainder of the liquidation horizon.
“The clearing of standardised derivatives was an explicit regulatory objective, but regulators also recognised the importance of a healthy non-cleared market to allow end users to precisely hedge bespoke risks,” says Scott O’Malia, chief executive of ISDA. “Now is the time to assess the risk-appropriateness of the regulatory framework, and whether the margin treatment for non-cleared trades is resulting in higher than necessary costs for end users.”
The paper offers what it terms a “more realistic assessment” of closeout risk for non-cleared transactions and leads to an outcome that is, in general, “quite different from the risk exposure of the netting set over the liquidation horizon”.
“The framework for calculating initial margin requirements has been imported from existing practices for cleared derivatives, except that regulators have increased the margin period of risk, presumably because there is a perception that non-cleared derivatives are intrinsically harder to close out or unwind if one counterparty defaults,” says Professor Cont. “Our study questions the rationale for this approach, and advocates an alternative that takes into account the default management process, as well as the size and complexity of trades.”