On 28 June 2022, the UK’s Prudential Regulation Authority (PRA) published a letter to the Chief Risk Officers of banks operating under its jurisdiction. The letter details its review of the market’s use of ISDA’s Standard Initial Margin Model (SIMM); the review was intended to assess the SIMM’s performance during recent periods of market stress and its broad compliance with margin Regulations. Even couched in the BoE’s calming tones, the letter makes for slightly alarming reading.
Areas of concern
The letter highlights two areas of ‘potential concern’.
- Back-testing. The SIMM uses 1+3 back testing as a calibration standard as well as a performance metric; one year of stressed market conditions and the previous 3 years of market data. Regulations stipulate that the SIMM (or any applicable internal model) should cover risk to a 10 day period with a 99% confidence level. The PRA is concerned that using a similar data set for both calibration and testing essentially amounts to the SIMM marking its own homework. Its concern is that the resultant IM calculation may be insufficient to comply with mandated risk cover.
- Hedge Funds. The letter acknowledges that Phase 6 IM will see the entry into IM scope of a large number of hedge funds, firms with risk profiles which may be significantly different to the vast majority of earlier entrants to the IM regime. The PRA observes that some of these portfolios risk being systematically under-margined for two possible reasons:
- Their portfolios include risks which are not currently modelled by the SIMM i.e. stress data is updated annually and will therefore not include more recent volatility. 1+3 back-testing is unsurprisingly insensitive to non-modelled risk factors, resulting in no perceived need to remediate.
- SIMM back-testing exceptions are subject to a large absolute threshold for model shortfall, a factor which may exacerbate the issue identified above.
The PRA goes on to point out that 14(3) of the Margin RTS requires P&L back-testing rather than just 3+1 stress tests. It acknowledges that while P&L back testing is performed by some firms, the results are not universally incorporated into relevant SIMM governance processes. This is presumably a criticism of the firms’ implementation, given that the ISDA recommended governance framework does recommend calibration against 10 or one day actual P&L movements.
The PRA’s expectation
The PRA expects to see the following by December 2022:
- a self-assessment of firms’ implementation of OTC derivatives margining requirements including consideration of:
- the observations raised in the letter;
- compliance against article 14 of the RTS; and
- the role played by P&L back-testing in the firm’s own SIMM model governance;
- a corrective action plan for any gaps identified in 1.
The SIMM model is not merely Standard, it is Universal. To date, there is no single entity which has availed itself of its right to use an internal risk model for IM calculation. Given obvious issues around Regulator and counterparty approval of internal models, the SIMM will continue to be the market standard, even if not entirely golden. The SIMM was never intended to be a fire and forget solution, leaving updates to the good offices of ISDA. Even assuming a sound initial framework, all financial models are subject to drift, constant monitoring and re-calibration to fact are essential. The RTS requires P&L back testing, ISDA recommend it, the PRA’s letter makes it abundantly clear that firms must use the SIMM responsibly and will be found responsible if they do not.Contact Us