LCH SwapClear have just implemented a change in their Initial Margin methodology and this article will discuss three elements that constitute the change:
- Historical look-back period, increased from 5Y to 10Y
- Relative scenarios changed to absolute scenarios
- Worst Loss to Expected Shortfall
This is the most obvious change, because as we approach the 5Y anniversary of the market shocks experienced in 2008 (e.g. Lehmans Bankruptcy Sep 1998), this data is about to drop out of the historical lookback period. In much the same was as Basle Committee introduced Stressed VaR as a change to the Market Risk Capital requirement, the ten year look back period serves to keep the large scenarios shocks that were experienced by the market in 2008, in the dataset for a further 5 years.
Impact: Initial Margin will not suddenly drop in Sep 2013 for many portfolios.
In 2008 interest rates in most major markets were 3% or above , but Central bank intervention has resulted in these rates being held at 1% or less for a number of years now. Using a relative return methodology, a +50 bps shock in 2008, is first converted into a relative return of 0.5/3.0 or 16.67% and applying this to todays rates of 1%, results in 1.167%. However using absolute returns the same 50bps shock in 2008, results in a shocked rate today of 1.5%. So using relative returns from a higher rate environment on a low rate environment, meant that shock scenarios were being under-stated and the absolute return scenarios adjust for this.
Impact: Higher Initial Margins as scenarios will be larger.
The prior methodology defined IM as the worst loss scenario from 1250, while the new methodology uses Expected Shortfall or the average of the six worst scenarios out of 2,500. The advantage of this change is that IM is not solely determined by the loss on a single scenario and so very sensitive to change. By averaging the worst six scenarios, we have an IM that is more stable, so less prone to large day on a day jumps.
Impact: More stable IM and lower IM.
In general we expect Initial Margin for most portfolios to be significantly higher now and even more so after Sep 2013. While the magnitude of the increase depends on the risk characteristics of each portfolio, on average we would expect that many portfolios will have seen an IM increase of 30% or more. Largely driven by the change to absolute returns.
This is consistent with the stated aims of LCH SwapClear in changing their methodology; to improve margin cover in a low rate environment, create IM stability and improved defaulter pays (higher IM) over all members contribute (lower default fund contribution).