The tables are being turned on banks that led the development of the swap market’s standard initial margin model (Simm) – they may have called the shots in the model’s design, but are set to be massively outnumbered in the polling mechanism that ultimately determines how much margin it generates.
Currently, 22 banks submit daily votes on how to apply the multiple risk buckets in the Simm – a model designed for use by the entire swaps market – but scores of buy-side firms could join them, as the scope of the market’s margining regime for non-cleared derivatives expands over the next two years.
Banks are split on the potential influx of hedge funds, asset managers, insurers and others, with some claiming they would be willing to pay their clients’ sign-up costs in order to promote wider use of Simm, and others fretting buy-side firms may collectively set margin requirements that are too low.
“There’s always been a preference to limit the role to regulated banks,” says a margin manager at a European dealer, who claims the consensus view at one point was that buy-side firms should be excluded from voting.
That view has not prevailed, with Ice Benchmark Administration (IBA) – which runs the daily polling mechanism for Simm – and the International Swaps and Derivatives Association, which developed the model, now calling for wide participation.
“The more firms that submit their votes for the bucketing, the more the results will accurately reflect the market view,” says Tara Kruse, global head of infrastructure and data at Isda.
Polling allows derivatives users to vote on how different products should be assigned to the various buckets of risk that are the end-point of Simm’s classification system. Simm seeks to be accessible by breaking products down in a standardised way – by asset class, risk factors and buckets – with pre-set risk-weights assigned to the buckets that set the appropriate margin amount.
IBA signed the first asset manager in July to this facility. The firm will initially take results from the facility for use in its margin calculations but, once it is in scope for the initial margin rules – likely in September 2019 – it is expected to become the first asset manager to join banks in submitting daily votes on how to assign equity and credit derivatives underlyings to the various risk buckets that determine margin calls.
The more firms that submit their votes for the bucketing, the more the results will accurately reflect the market viewTara Kruse, Isda
“It’s our expectation that phase one for the asset management community will be to take results, phase two will be when they start voting on their positions as they get comfortable with how the system operates,” says Tim Bowler, president of IBA. “By the end of this year, we hope to have a good proportion of the asset management community using the results. When they are subject to the rules and have skin in the game, they’ll probably start voting.”
As many as 1,000 buy-side firms could be brought into scope for initial margin rules as part of the fifth and final implementation wave in 2020 – the ‘IM big bang’ in which the compliance threshold drops to $8 billion in aggregate average notional amount of non-cleared derivatives outstanding.
Brevan Howard is currently the only buy-side firm subject to IM rules. The hedge fund fell into scope in September as part of the third wave of implementation, which saw the compliance threshold drop to $1.5 trillion.
Bowler is encouraging fourth- and fifth-wave firms to sign up to the facility ahead of compliance deadlines, and sees polling of their risk opinions as part of a broader democratisation of risk management across financial markets.
“If the buy-side community links up to the crowdsourcing model, where they can express their views on risk and their vote has equal weight to the sell-side community, it could be a very interesting tool that would democratise how risk levels and valuation thresholds are set in markets for non-exchange-traded instruments,” says Bowler.
The fee model for the facility has not yet been decided, but voting rights will not come for free – so wider membership will also benefit IBA commercially.
The many, or the few
Some dealers remain sceptical about the benefits of a diverse voting population. While banks are actively encouraging their buy-side counterparts to adopt Simm – a model that has become standard among entities caught in the first three waves of compliance starting September 2016 – some stop short of welcoming them onto the mechanism that determines risk weights for margin calculation, and view buy-side inclusion as a reversal of earlier industry thinking.
“It’s generally been understood that the buy side would be excluded [from the voting mechanism] as there’s a worry they could put in some very low numbers,” says the European dealer’s margin manager.
The facility’s equal-weight polling system means the views of a limited cohort of sell-side firms could easily be overshadowed by hundreds of votes from the buy side, which may hold a fundamentally different view.
“I can see how the buy side could game it in the wrong direction to lower IM, but if it passes backtesting I’m not sure it’s a problem,” says a margin manager at a US house. “I can’t imagine the buy side would want to game it in the other direction to raise IM, so I can’t see a strong argument against including them, but I struggle to see the value.”
IBA’s Bowler accepts asset managers may hold a fundamentally different view from the dealer community, but says a bigger, more diverse group of voters will make the model more credible. He argues internal surveillance will stamp out any attempt to manipulate results.
It’s generally been understood that the buy side would be excluded [from the voting mechanism] as there’s a worry they could put in some very low numbersMargin manager at a European dealer
“Getting more constituents signed is important because if there are 10 people voting, someone has a greater ability to affect the outcome than if there are 200 people voting,” says Bowler.
A third margin official at another international dealer supports any efforts that encourage greater buy-side participation in Simm. If the model is not embraced by banks’ clients, the result could be conflicting margin calculations.
“More participants using IBA will further reduce disputes, as then we are all using same risk buckets,” he says.
The rules of the facility only permit participants to vote on risk buckets for underliers they hold a position in, with a minimum of two votes required for an individual International Securities Identification Number (Isin) to be assigned to a risk bucket. The bucket with the most votes for each instrument determines the risk weight for margin calculation under Simm. Risk weights are pre-determined for each bucket by Isda’s Simm working group and assessed on an annual basis.
For underliers that fail to meet the minimum requirements, firms must bilaterally negotiate a risk bucket or agree to use residual risk weights.
Individual members typically submit daily votes ranging from a few hundred to as many as 21,000.
Expanded participation could improve coverage, according to Bowler. The facility currently publishes more than 18,000 Isins per day, up from around 11,000 when it went live in 2016. That could further increase with the addition of buy-side firms.
“A large proportion of the dealer community is actively using and voting in our crowd-sourcing facility, and we have pretty broad coverage of the exposures that exist, but there are a number of Isins we don’t publish. As the buy side come on board, we do expect more underliers to reach the two or more votes they need,” says Bowler.
IBA’s Bowler believes the development of a buy-side network through the crowdsourcing facility could be the start of a more active role for those firms in the valuation of assets – particularly in illiquid instruments.
He envisages the development of information exchange platforms that allow holders of privately placed instruments such as asset-backed securities and collateralised loan obligations to submit pricing opinions. Consensus valuations could then be determined, allowing owners of illiquid assets to mark their books without the need for costly external valuation experts.
“If buyers and sellers of a private placement are linked together to express valuation through a voting mechanism and you can get a well-supported median price on the back of it, then you have a consistent way in which valuation can be delivered across the asset management community,” says Bowler.
“It potentially allows that community to express a view on valuation of less liquid instruments collectively and anonymously, and if you want to use that as your mark, I think it should be as acceptable as having an outside firm come and do their own modelling.”
The first step in realising that vision requires widespread buy-side adoption of Simm – something that is far from guaranteed.
Dealers say it can deliver higher collateral requirements for heavily directional portfolios than firms might face under the regulators’ grid methodology.
One margin expert told Risk.net the industry-backed model produced a four-fold increase in the collateral requirement for his bank’s equity derivatives portfolio when compared to the grid approach.
Others argue such cases are the exception. The first margin manager says sample calculations on a non-cleared derivatives portfolio of one large sovereign wealth fund delivered a 30% collateral reduction under Simm when compared to the grid methodology.
Another issue is cost. IBA’s crowdsourcing facility is currently offered free to members, but charges will apply from 2020. According to the margin manager at the US house, persuading buy-side firms to pay to express their views will be an uphill struggle.
“If I were on the buy side, I’m not sure I’d pay. I would just take the published results, bucket everything appropriately and run Simm. I don’t see that buy-siders really care about inputting their risk views as long as they get a value they can use in Simm.”
Fees are yet to be negotiated, but are expected to be in line with charges currently levied by IBA for its Libor licences. A cost-recovery pricing structure is anticipated, meaning fees should fall as participation increases.
But cost-recovery pricing structures are not always popular. Dealers and trading venues have slammed the pricing structure at Anna DSB, the European utility tasked with creating Isins for derivatives instruments under Europe’s second Markets in Financial Instruments Directive, which became effective at the start of 2018.
The agency irked many of its clients after hiking fees by more than 70% for its most active users earlier this year, after fewer firms than anticipated signed up for the service.
With dealers set to reap the benefit of widespread Simm adoption, one source says his bank would foot the bill for clients.
“I don’t think the buy side necessarily has to submit to the crowdsource to make this work, but in the context of Simm more generally, where we all pay a licence fee, I’d definitely want to pay the way to drive model adoption. A $100,000 fee across all my counterparties is nothing, whereas a small fund that gets pulled into scope might be reluctant to pay that,” says the US margin manager.
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