On the horizon: validating initial margin models

18 May 2022

After the 2008 financial crisis, global leaders agreed that over-the-counter (OTC) derivatives need more transparency and better risk-mitigating tools, as they are not centrally cleared by an exchange. In the EU, this regulatory effort led to the European Market Infrastructure Regulation (EMIR), which obliges market participants to exchange collateral for non-centrally cleared OTC derivatives, in the form of variation or initial margin. Initial margin is posted at the outset of a derivative trade to cover potential future exposure arising in the time between the last exchange of margin and the liquidation or hedging of the position. This obligation is subject to thresholds and has been phased in since 2017. From September 2022 onwards, all counterparties will need to start exchanging initial and variation margins if their average aggregated notional amount of OTC derivates exceeds €8 billion at group level.

In the coming years, European banking supervision will start validating banks’ risk management procedures, including the initial margin models that they use to calculate required payment amounts. These new validation requirements will be regulated by the Regulatory Technical Standards on initial margin model validation under EMIR to be issued by the European Banking Authority. ECB Banking Supervision calls on all affected banks to prepare themselves to collaborate with supervisors on model validation, regardless of whether their models were developed in-house, by their counterparty, or by a third party (such as the Standard Initial Margin Model (SIMM) that was developed by the industry).

The ECB is currently designing a supervisory validation process for initial margin models of significant banks. For this purpose, ECB Banking Supervision has surveyed exposures of 99 significant banks to OTC derivatives and whether they use, or intend to use, initial margin models. The survey also covered the type of model and the implementation timeline. By gaining a clearer picture, the ECB is aiming to establish an efficient and timely validation process for banks subject to the new requirements. A sound and reliable validation process of initial margin models will help maintain a level playing field and keep the banking system stable, as the safety, quality and adequacy of models will be controlled. By engaging with the industry early through this survey, the ECB is taking a proactive approach in assisting those banks which will need to have their models validated.

This will require an effort by both the industry and supervisors, as 70% of surveyed banks will be required to exchange initial margin by September 2022, and 50% are currently using at least one model for initial margin calculations – with 40% using models as their general policy. The bigger a bank is, the more likely it is to use a model. Some larger banks also use more than one model for initial margin calculations. Smaller institutions are more likely to use the standardised grid approach (defined by regulators) as a cost-saving measure, due to its simplicity.

Most large banks that choose to use a model for calculating the initial margin rely on the SIMM, or a slight variation of it, for most or all transactions involving initial margin requirements. While this widespread adoption by the industry may simplify the validation task, banks should remain aware that all these models also have to be validated and supervisors would need to understand any model adjustments.

With these observations in mind, the ECB intends to work closely with national competent authorities and banks to make the process of validating initial margin models prudent, efficient and transparent. ECB Banking Supervision aims to have the model validation process designed by the time the corresponding regulatory process has been finalised. In the meantime, the ECB expects banks to monitor the development of new requirements closely, plan accordingly and assign resources and responsibilities for this task.