Bank of England warns some companies could be systematically under-marginated for UMR
The Bank of England’s Prudential Regulation Authority (PRA) has highlighted issues with the governance of the Standardized Initial Margin Methodology (SIMM) model and companies’ abilities to identify and correct underperformance of the model.
The review sheds light on the upcoming UMR Phase 6 deadline on September 1, impacting the largest number of buy-side companies so far.
“In our view, the existing governance process, in which companies rely primarily on the International Swaps and Derivatives Association (ISDA) to update the SIMM or negotiate add-ons when the model underperforms, may result, for some counterparties, in insufficient margin levels to cover risks at a 99% confidence level as required by regulation,” the PRA said in its review letter.
Two potential areas of concern were highlighted by the PRA in its review. First, several limitations related to 3+1 back-testing – a historical methodology introduced by ISDA as the main performance measure for SIMM – have been identified. Namely, the use of in-sample data as well as the limitations of not considering unmodeled risk factors in the testing process.
Due to these limitations, PRA suggested that 3+1 does not always adequately identify poorly performing models as required by Regulatory Technical Standards (RTS). The regulator noted that in cases where the 3+1 performance measure is unsatisfactory, the resulting Initial Margin (IM) may not be sufficient to cover risks at the 99% confidence level, such as the requires RTS for certain counterparties.
The PRA also observed that companies relying primarily on the global ISDA governance process to update the SIMM or negotiate add-ons may not be sufficient to ensure timely action is taken to remedy to model underperformance – which is fundamentally the companies own responsibility under the RTS.
“These results are unrelated to the specifics of the model’s design, such as a calibration methodology that is relatively less sensitive to current market data. Our main goal is to ensure that scope companies are sufficiently margined (as defined by the RTS) on an individual portfolio basis and meet the requirements of the RTS,” the PRA added.
Impact on hedge fund portfolios
As the UMR Phase 6 deadline approaches, more hedge funds than ever before will be impacted by regulation. The PRA said that “these funds may have portfolios with significantly different risk profiles from those to which the SIMM has been applied to date. These portfolios may also be significantly exposed to risk factors that are not directly modeled in SIMM, due to their overall materiality.
The PRA observed that, under the existing practices of companies using SIMM, back-testing exceptions are only considered for correction – either by companies applying IM add-ons or by ISDA modifying SIMM – only if the deficit of the model exceeds a large absolute threshold. Another observation is that 3+1 back-testing is generally insensitive to unmodeled risk factors.
“This means that, if companies do not act, certain portfolios risk being systematically under-marginated, for example when the overall deficit is below the ISDA materiality threshold and/or the underlying risk factors are not not modeled in SIMM,” PRA noted.
Concluding its review letter, the PRA said it expects to see evidence that under-margin risk is being addressed by individual companies through self-assessment as well as providing a plan corrective action plan for any shortcomings identified by the assessment.