PRA Review on ISDA SIMM® – Background
With the upcoming (Uncleared Margin Rules) UMR Phase 6 deadline in mind, the Prudential Regulation Authority (PRA) has carried out a comprehensive review of the ISDA SIMM® model. The focus of this has been from the viewpoint of Phase 1 Firms and focuses on two areas of International Swaps Derivatives Association Standard Initial Margin Model (ISDA SIMM) Model Governance and the Phase 1 Firms’ ability to identify and remediate model underperformance in a timely basis.
The driving factors behind this study are attributed to market volatility driven by macro events from COVID-19 and the Ukraine War, along with isolated events such as the Archegos collapse. The associated risks have been highlighted with a specific focus on Hedge Funds, who will form the majority of the participants in scope for Phase 6, with many of the smaller firms being caught by the regulation. The view is that many hedge fund portfolios have bespoke risk profiles that are not appropriately modeled in the SIMM framework.
In December of last year, the PRA had a similar letter outlining the failure in risk management controls and governance it found on the back of the Archegos collapse
The overlapping theme between these two letters and what is most applicable to Hedge Funds is the point around a robust margin methodology to reflect different exposure profiles across concentration and illiquidity risk. The Archegos letter is more focused on equities financing activities of banks and here the synthetic or Equity Total Return Swap (TRS) instruments overlap with UMR.
House margin models which have dynamic portfolio based margin calculations, will capture additional margin requirements where Equity TRS underliers don’t have a very liquid market (e.g. low daily traded volume) or the fact that the portfolio has less than a certain number of positions, with portfolio concentration charges. Whereas, in the SIMM world this would have a consistent margin based on net delta sensitivity the associated risk weight and correlation offset.
Another point of note from the Archegos letter is on the limit frameworks that business risk functions at Banks have for their counterparties. This not only revolves around risk exposure but also gross notionals’ traded. As an indirect consequence of this, Phase 6 firms, and in particular hedge funds, should have the ability to replicate and monitor the limits that dealers place on their portfolios; such that they are not forced to close out positions impacting fund performance.
Further, the PRA ISDA SIMM® letter highlights that it considers the 3+1 back-testing insensitive to the non-modeled risk factors of hedge fund portfolios. Here they have an expectation for Category 1 Banks to review the role of back-testing in firms’ own model governance and have corrective action to remediate any potential breaches.
Industry View and Expectations
Overall SIMM has held up well through the COVID-19 period when compared with CCP models. The consensus view is that SIMM is robust enough to deal with periods of unexpected market volatility. Per our analysis, on a standalone Interest Rate Swap (IRS) trade on an OIS index, the SIMM margin is almost 50% higher than comparable CCP margin.
Further, SIMM has a more comprehensive risk coverage for bespoke strategies in comparison with house margin that Tier 1 banks charge. When looking at SIMM margin against house margin charged for bespoke hedge fund strategies, we have found SIMM to be more conservative. Looking at an example of equity pairs trading where house margin ranges from 6-8% of gross exposure and SIMM attributes a 15-18% margin for the same portfolio of trades.
Requirements around back-testing and benchmarking are quite onerous for smaller firms. These can make the process operationally intensive, which isn’t the intention of the ISDA guidelines. ISDA recalibrates SIMM every year; it also has the capability of an intra-year recalibration where there is sufficient evidence it is not robust in capturing portfolio risks. As such, any shortfalls experienced will be captured by this mechanism.
Impact on Hedge Funds and How to Approach This
- Phase 1 Dealers will carry out a comprehensive review of counterparty risks Hedge Fund portfolios have to them, including wider internal stress testing, extensive back testing, and scenario analysis.
- Remediation actions may result in applying Add-Ons to SIMM – these can be fixed or dynamic as a function of risk factor and risk type. Or, moving to use Standard Schedules or GRID methodology for trades causing exceptions.
- Ancillary to SIMM, hedge funds may be subject to specific risk exposure or trading limits, change of internal house margin methodology, reviewing UMR thresholds or even the House vs SIMM approach (Greater of, Distinct or Allocated).
- Hedge Funds will need to have their own benchmarking and back testing of SIMM to add weight to their negotiations with dealers.
- Clients will also need the ability to attribute the various Add-Ons they are subject to, to ensure transparency and reconciliation of daily margin. Switching between SIMM and GRID or being able to replicate house methodology for a House vs SIMM approach will also be crucial.