WHY THE ISDA SIMM METHDOLOGY IS NOT WHAT I EXPECTED

Amir Khwaja (https://www.clarusft.com/author/amir/) November 23, 2015

2 comments (https://www.clarusft.com/why-the-isda-simm-methdology-is-not-what-i-expected/#comments)

At the end of myarticle on Final US Rules for Non-Cleared Swaps (https://www.clarusft.com/nal-us-rules-on-margin-for-non-clearedswaps/), I noted that I would look at ISDA (https://www.clarusft.com/glossary/isda/)s Standard Initial Margin
(https://www.clarusft.com/glossary/margin/) Model (SIMM). On doing so, I was surprised to see the direction that ISDA is now taking, one
that I did not expect. Read on to nd out why.
Background
The ISDA SIMM methodology was rst made public in December 2013, with the publication of this document
(https://www2.isda.org/attachment/NjE2Ng==/SIMM%20for%20Non-cleared%2020131210.pdf).
I recall reading this and being in general agreement with the methodology outlined:
1. Two calculations steps, market shocks applied to portfolio and then an aggregation method
2. 99% condence level over a 10-day margin period of risk
3. Model validation, supervisory co-ordination and governance
4. Use of portfolio sensitivities (greeks) rather than full revaluations
5. Inclusion of collateral (https://www.clarusft.com/glossary/collateral/) haircut calculations within the calculation
In particular the recommendation of using risk sensitivities struck me as a sensible approach given the diculty in agreeing pricing
models for every type of exotic derivative and the performance requirements of non-analytic models.
What I Expected
Given this, I expected ISDA SIMM to be a standard Historical Simulation Value-at-Risk analysis, but one that used risk sensitivities as
inputs.
Why?
Because every CCP (https://www.clarusft.com/glossary/ccp/) that clears Interest Rate Derivatives (by far the largest Asset Class) uses
Historical Simulation.
From LCH (https://www.clarusft.com/glossary/lch/) SwapClear with $trillions cleared (https://www.clarusft.com/glossary/cleared/) over
many years, through to CME (https://www.clarusft.com/glossary/cme/), JSCC, Eurex, SGX, ASX, HKEx,
Historical Simulation is the most common method used for market risk monitoring and risk capital (Basel II).
Market participants have existing systems that implement the methodology.
The industry has many years of experience in using the methodology, including lessons learned from the Financial Crises of 2007-8,
resulting in the concept of Stressed VAR.
So a reasonable enough expectation and nothing in the ISDA SIMM document led me to believe otherwise.
ISDA WGMR
Imagine my surprise when I decided to look at the current progress of theISDA Working Group on Margin Requirements (WGMR) and
found that ISDA SIMM has developed quite dierently.
Current documents can be found at theISDA WGMR Implementation Initiative page (https://www2.isda.org/functional-areas/wgmrimplementation/), whereon October 1, 2015, a Discussion Document, the Methodology v3.2 and Risk Data Standards documents were
published.
My original intention had been toreview and provide an outline of the Methodology document, but while there is much of interest
there, I am afraid so far I have failed to get over my shockof not nding the details of a standard Historical Simulation approach.
Instead I found a methodology that I do not entirely recognise.
Below are a fewextracts from the document that are applicable to Interest Rate risk:

(https://cdn.clarusft.com/wp-content/upLoads/2015/11/Screen-Shot-2015-11-23-at-

17.28.20.png)

(https://cdn.clarusft.com/wp-

content/upLoads/2015/11/SIMM-1a.png)

(https://cdn.clarusft.com/wp-

content/upLoads/2015/11/SIMM-5a.png)
It looks a bit like Parametric Value-at-Risk, in that there are tables of risk weights for interest rate factors in regular, low volatility and
high volatility currencies and a matrix of correlations.
But it is dierent enough to not be Parametric VaR (also known as Variance Co-Variance).
And given that there is aPatent Pending footnote on the rst page of the document, the positioning is clearly that this is a new
methodology being proposed.
Do we really need a new methodology?
And is it really simple and easy to replicate?
How often have IT folks heard from a business user that it is really simple and then many months/years later with thousands/millions
under the bridge it becomes evident that there was a lot of devil in the detail.
A History of VAR
Those of you old enough and with a good memory, will recall that in 1994 JP Morgan published its RiskMetrics methodology. Useful links
on this include Wikipedia (https://en.wikipedia.org/wiki/RiskMetrics), Investopedia
(http://www.investopedia.com/ask/answers/041615/what-riskmetrics-value-risk-var.asp),Introduction to the 4th Edition
(http://janroman.dhis.org/nance/Risk%20Management/Introduction%20to%20riskmetrics.pdf),Technical Document
(https://www.msci.com/documents/10199/5915b101-4206-4ba0-aee2-3449d5c7e95a).
RiskMetrics introduced the three commonly accepted VaR methodologies; Parametric, Historical Simulation and Monte-Carlo
Simulation.
The advantages and disadvantages of each are well covered in the literature and standard text books e.g.Philippe Jorion
(http://www.amazon.co.uk/Value-Risk-3rd-Ed-Benchmark/dp/0071464956/ref=sr_1_1?s=books&ie=UTF8&qid=1448292517&sr=11&keywords=value+at+risk), Carol Alexander (http://www.amazon.co.uk/Market-Risk-Analysis-ModelsFinance/dp/0470997885/ref=sr_1_12?ie=UTF8&qid=1448292839&sr=8-12&keywords=value-at-risk), Glyn Holton
(http://www.amazon.co.uk/Value-at-Risk-Theory-Practice-Glyn-Holton/dp/0123540100/ref=sr_1_1?ie=UTF8&qid=1448292930&sr=81&keywords=glyn+holton). For those needing a short refresher, see my Value-at-Risk presentation
(http://www.slideshare.net/clarusft/value-at-risk-22762966/)and no doubt there are many others searchable by Google.

I am not going to try and cover these pros and cons of each method again, suce to say that over thepast twenty years, the de-facto
standard has emerged as Historical Simulation.
Not only have global banks been using Historical Simulation internally for many years, they have also beenreporting these gures to
regulators and publishing in their annual reports.And since 1999, LCH SwapClear has been using Historical Simulation for the
calculation of Initial margin.
Forme it makes the most practical sense to use Historical Simulation for non-cleared derivatives.
Final Thoughts
The ISD WGMR documents all have a page header as follows:

(https://cdn.clarusft.com/wpcontent/upLoads/2015/11/Screen-Shot-2015-11-23-at-17.03.10.png)
I for one hope that the red-text is indeed true and that WGMR members re-consider.
Standardising on Historical Simulation would be a far better way to go.
Market participants will then be able to utilise their existing investments and real-world experience.
There is a value to the industry in standardising the denition of risk sensitivities.
There is even more value in specifying risk data standard formats.
There is value in specifying historical periods to be used for each asset class.
There is even more value in providing standard scenario data for these periods.
Lots of work for the ISDA WGMR to do.
Lets hope it gets done as September 2016 isless than a year away.

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2 THOUGHTS ON WHY THE ISDA SIMM METHDOLOGY IS NOT WHAT I EXPECTED

Bill says:

November 24, 2015 at 9:33 am (https://www.clarusft.com/why-the-isda-simm-methdology-is-not-what-i-expected/#comment-1397)

Whilst you may be shocked and surprised the move to a new model for IM will generate work for many people to build, implement and test
the ISDA SIMM, which can only be a good thing. Id like to see ClarusFT build that model and run a comparison against HVaR to see how the
distribution compares, and ultimately the relative eectiveness of the two models in the various asset classes.

Amir Khwaja (http://www.clarusft.com) says:

November 24, 2015 at 9:59 am (https://www.clarusft.com/why-the-isda-simm-methdology-is-not-what-i-expected/#comment-1398)

True that there are Pros and Cons to that and depending on your perspective one outweighs the other.
However on balance I do not think it is a good thing for the market as a whole.

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