The way the industry addressed new regulatory requirements to exchange margin on uncleared derivatives sounds very progressive and edgy – it's a crowd-sourced and dynamic model that caters to the needs of a whole community of firms, financial and non-financial, large and small.
However, in practice, the standard initial margin model (Simm) may turn out to be a bit utopian in an industry that doesn't do progressive and edgy very well. The development of the model within the International Swaps and Derivatives Association by itself required two years of deliberation among the core group of the largest financial firms. Still un-standardised and in some cases undefined are a range of other factors underpinning the Simm, such as model inputs, governance and backtesting. As the number and diversity of firms subject to margin rules increases, lack of standardisation could make for increasing inconsistencies, while also resulting in a larger group of stakeholders less able to agree on how to address them.
Simm backers say critics are mainly scare-mongering software companies trying to cash in by serving as standardisation platforms. They say since US, Canadian and Japanese margin rules were launched in September, initial margin (IM) disputes have been few and far-between, meaning there is little urgency to standardise further.
But the counterargument is that it's one thing for two huge global banks to come out with reasonably similar sensitivities and IM numbers, and another to expect the same between a large bank and a smaller and less sophisticated firm in a different jurisdiction. Today, disputes occur within a group of 21 banks probably all used to working together and negotiating on some level. In the future, disputes will be between very different firms on far less cosy terms.
Regulators, for their part, have done little to contribute to pressure for further standardisation, and in some ways, have made it more difficult. In the US, official conditions around governance and backtesting stopped short of prescribing specific remedies. Meanwhile, differences in the scope of the regulation across jurisdictions will make it hard to agree on trade populations.
Perhaps one of the most glaring examples of the lack of consensus is the absence of a definition for when the model has failed – either in terms of daily margin calls, or in effectively covering the 99% 10-day risk scenario. An attempt to define when a daily margin difference constitutes a dispute was rejected; meanwhile, no-one knows when the number of backtesting exceptions requires action.
Even if breaches or exceptions aren't bad enough to result in official disputes, that doesn't mean they are frictionless. According to one expert at an international bank, the list of breaches is growing longer and will require beefing up a separate team of staff to monitor, investigate and address them. Those breaches are expected to get more numerous and wider as the use of the Simm is expanded to apply to more users and risk factors, and if differences in sensitivity calculations worsen with higher market volatility.
Simm backers rightly emphasise that all these questions are being considered in a fully democratic forum that can address problems when they arise. And so far, participants in that forum have rejected further standardisation. Some argue it would risk making Simm governance too complex; others say it is simply not in firms' interests. And some admit it's probably because democratic consensus is hard to come by.
The risk is that a lack of standardisation means loose ends will constantly have to be tied. That could also be prohibitively expensive and even disrupt trading, argue some. It's enough to make one banker say it makes more sense to go back to using the standardised grid approach, as higher margin requirements would be offset by cheaper implementation costs and lower trading friction. Regardless, what is clear is that the story of the Simm did not end with its launch last September, and the model will inevitably face significant growing pains.