Oct 9, 2014

Navigating the Murky Waters of Initial Margin for OTC Derivatives

Initial Margin (IM) is a significant aspect of the bilateral and centrally cleared derivative markets, as regulators strive to reduce systemic risk in the global OTC markets. However, it does not come without a price. Not long ago, we discussed how word on the Street was that, in addition to operational and legal challenges, the newly proposed margin requirements for uncleared swaps could become 40 to 45 percent higher than for cleared transactions.1

Given the prevailing uncertainty, many of today’s OTC derivative participants are currently experiencing challenges as they begin to navigate new initial margining (IM) regulations—and the resulting shift in margining practices.  

So, with current IM methodologies not yet standardized across the market, what is the best way to navigate this murky labyrinth? For firms who are unaccustomed to posting IM, which IM methodology should they use for pre-trade decision-making and collateral optimization, or to verify post-trade calculations from CCPs or bilateral counterparties? Most importantly, how will IM affect their derivative business’ costs and processes?

Breaking Down the Regulations

Despite the release of the second consultative document outlining the near-final policy for consistent standards last year by the Basel Committee on Banking Supervision (BCBS) and the International Organization of Securities Commissions (IOSCO), ambiguity still persists when it comes down to managing non-centrally cleared derivative margin requirements. To help break it all down, we’ve outlined at a high level what we consider the eight key principles and requirements for non-centrally cleared trades:



  1. Required Margining: Margining practices are required for all derivatives not cleared by CCPs.
  2. Initial and Variation Margin: Users of non-centrally cleared derivatives must exchange initial and variation margin.
  3. Methodology: Methodologies for calculating initial and variation margin must reflect the potential future exposure and current exposure, and all counterparty risk exposures associated with the portfolio of non-centrally cleared derivatives.
  4. Collateral: Collateral assets should be highly liquid and be able to hold their value in a time of financial stress.
  5. Protection: Initial margin should be immediately available to the collecting party in the event of the counterparty's default; and be protected in the event of bankruptcy.
  6. Local Regulation: Transactions are subject to each jurisdiction's legal and regulatory framework.
  7. Consistency: Regulatory regimes should strive for consistent and non-duplicative regulatory margin requirements across jurisdictions.
  8. Coordinated Approach: Margin requirements should be phased in over an appropriate period of time to ensure a coordinated review of the margin.



  1. Initial Margin (IM) may be calculated by reference to either a quantitative portfolio margin model or a standardized margin schedule. According to the Quantitative Impact Study, the use of internal models typically result in lower margin requirements than the standardized margin schedule.
  2. Internal or third-party quantitative models can be useful for ensuring initial margin amounts are calculated in a risk-sensitive manner. Working Group on Margining Requirements (WGMR) seem to encourage the use of internal models, especially for more complex products.
  3. Regulators must always approve internal models. Even in the case of a 3rd party model that has already been approved within the same jurisdiction for a different institution.
  4. Portfolio Margin calculation is allowed, but only within asset classes.
  5. Market participants will not be allowed to switch back and forth between internal Initial margin models and regulatory schedules, as in the case with CVA models (Credit Valuation Adjustment).
  6. Market participants are allowed to choose the derivative classes for which to use internal models and for which to use schedule based approach. This decision, however, cannot be based on minimizing IM requirements.
  7. Given that IM has to be collected by both parties involved in the trade, there is no guarantee that the IM models, and the respective parameterizations used will be consistent between the counterparties. As such collateral disputes are bound to become an issue, and must be resolved.
  8. Calculation must reflect an extreme, but plausible estimate of an increase in the value of the instrument that is consistent with a one-tailed 99 per cent confidence interval over a 10-day horizon, based on historical data that incorporates a period of significant financial stress.

For a more detailed analysis of initial margin and its impact on the derivative markets, view our on-demand webinar, “Primer on Initial Margin and its Impact on Derivatives Markets.”

1Financial Technologies Forum, ftfnews.com, “Uncleared Swaps Hit with Steep Margin Increases,” September 5, 2014

 2Source: Basel Committee on Banking Supervision (BCBS), International Organization of Securities Commissions (IOSCO), Margin requirements for non-centrally cleared derivatives

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