By Stuart Smith, Co-Head Business Development Risk & Data, Acadia

ISDA SIMM (Standard Initial Margin Model) is a widely used industry standard model for calculating initial margin for non-cleared derivatives trades. It is designed to provide a consistent and transparent method for determining the amount of collateral that counterparties must post to cover the potential future exposure of their trades.

From a regulatory perspective, it has performed solidly. However, in making it possible for all firms to adopt the model, there are accepted weaknesses which need to be monitored by in scope firms using backtesting and remediated through the use of Add-Ons.

More recently, following concerns by the UK Prudential Regulation Authority (PRA), SIMM has undergone revisions to its governance model. These concerns included whether UK firms were effectively implementing SIMM’s current model governance framework and therefore were able to promptly identify and address model underperformance, especially during times of market stress. The PRA also underlined outstanding elements that needed to be addressed to ensure compliance with regulatory requirements.

As a result, there have been significant revisions to the governance model of SIMM which were published in March 2023. While these revisions don’t change the basic mechanics of the SIMM model, it does significantly affect the process around complying with it. We’ll explore how these recent revisions impact firms and crucially, what actions firms need to take in response.

Off-cycle Recalibration

In addition to annual recalibrations, off-cycle recalibration was introduced to ensure that major market shocks which drive a significant change in risk are adequately absorbed by the model. This is measured quarterly by collecting backtesting data. The quarterly addition reduces the maximum time between a major market shock and a recalibration from 23 months to 8 months, allowing firms to address model underperformance more promptly.

To date, we have seen one off-cycle recalibration, SIMM version (2.5A), which was triggered because of backtesting exceptions in Q4 2022 and was implemented from mid-July 2023. Rather than applying a general recalibration more broadly across all risk factors, the off-cycle recalibration targets specific risk factors and, in the case of 2.5A, this was interest rates. In doing this, it should make validation easier and quicker for firms.

Identifying Risks not in SIMM

ISDA’s SIMM Remediation Annex issued with the ISDA SIMM governance framework provides significant detail about how firms should handle generated exceptions. In particular, it clarifies what are and are not considered risks in SIMM. For example, it covers scenarios ranging from exceptions caused by market-observed risk weights being greater than those of SIMM risk factors, to the basis between a Loan Credit Default Swap and a Loan Credit Default Index, among many others.

Firms are required to address Risk Not in SIMM (RNIS) issues bilaterally when they occur. Typically, they would use Fixed Add-Ons at a product class level, identifying the products which are causing issues in the backtest. Firms should also agree a multiplier that provides a sufficient add-on to the SIMM in order to address the exception. These issues will also be submitted to ISDA to decide whether industry-wide action is required. The Remediation Annex clarifies the conditions for such action based on whether the issue is ‘systemic’, ‘persistent’ or ‘material’ and provides guidance to the types of action which would be taken.

This further justifies including Dynamic Backtesting into a firm’s SIMM governance regime. Whereas the approaches could be previously seen as alternatives, this provides a compelling reason to execute both.

Reduction of Thresholds

The revision to the remediation annex provides a significant drop in thresholds for almost all aspects of SIMM across portfolio monitoring, reporting and remediation. Reduction in these thresholds collectively impacts thousands of agreements. These revisions range all the way from obliging some firms to remediate for the first time due to reduced remediation thresholds, to significantly reduced red reporting thresholds. The remediation annex clarifies these changes in a great deal of detail that affect monitoring, reporting and remediation practices for firms.

Implications for the Derivatives Market

The PRA’s letter highlighting potential weaknesses with UK firms implementing ISDA SIMM and ISDA’s consequent response to this, highlight the ongoing challenges facing the derivatives market in the area of initial margin calculation. The fact that regulators such as the PRA are closely scrutinising these models is a positive and encouraging development.

It helps to ensure that the models are being appropriately implemented and governed and that this evolves with time as market conditions change and market participants follow new strategies. After all, if the market is constantly changing, constructive dialogues that lead to improvements in the models that we use to calculate initial margin can only be a good thing.