ISDA published a paper examining the margin framework for non-cleared over-the-counter ("OTC") derivatives. In the paper, Rama Cont, Chair of Mathematical Finance at Imperial College London, criticized the use of a flat 10-day "margin period of risk" for setting model-based initial margin requirements and outlined a framework for a more risk-based approach.
Professor Cont questioned the fixed 10-day liquidation horizon for calculating initial margin, noting that it bears little resemblance to actual liquidation periods (which depend on size and liquidity of the portfolio to be liquidated). As such, he called for a more "size-dependent" liquidation horizon, which would be calculated based on the size of positions relative to the market depth of the relevant assets.
In addition, Professor Cont argued that a more realistic model of liquidation would recognize that actual liquidation practices involve hedging portfolio risk during the liquidation period. A more "realistic assessment of the actual exposure," he added, would model unhedged and hedged periods of exposure to the defaulted counterparty during a closeout phase. To accomplish this, Professor Cont said sensitivity calculations already used in the ISDA Standard Initial Margin Model could be employed to increase the realism of assumed risk exposures without unduly complicating initial margin calculations.
Finally, Professor Cont outlined a four-step process for calculating initial margin requirements for OTC derivatives transactions.
Commentary / Jeff Robins
Regulators may not agree with all of the modeling assumptions in the paper. However, it is important in showing that a more realistic approach to modeling risk-exposure during a swap close-out period could be integrated into the regulatory standards for initial margin without necessarily over-complicating the modeling requirements. And as the paper makes clear, this should be a strong regulatory goal as the current approach both penalizes swap users with smaller and more liquid swap portfolios and potentially critically under-margins the largest and least liquid (read: most systemically risky) portfolios.
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