As a complement to the standard ISDA SIMM harmonization used by all market participants to calculate the IM, the approval of models is now coming into picture “to ensure initial and ongoing validation of those risk-management procedures.”
- The EBA RTS final draft, issued on July 7, 2023, comprises a series of procedures defined firstly by a qualitative aspect pertaining to a governance framework, and secondly by a quantitative one in the form of a backtesting process designed to assess the model performance.
- The scope of firms subject to the RTS is in line with the EMIR regulation and concerns European counterparties that exchange initial margin when entering into an OTC transaction.
- Due to the diverse range of market participants and the simultaneous requirement for regulatory compliance, the final draft distinguishes between two sets of counterparties. Each set is associated with a distinctive process: one standard and the other simplified.
- The application of either process aligns with the UMR phasing process, wherein the Aggregate Average Notional amount will be used to assess a 750-billion threshold.
- The validation process, whether in its simplified or standard mode, begins with the submission of a validation request. It then progresses to an assessment of aspects in terms of governance and backtesting methodology.
Focus on the Dual Procedures
- The Standardized Procedure is applicable to larger counterparties identified through the AANA calculation, which are more complex and capable of meeting the specified requirements. Other counterparties will be subject to a simpler framework known as the Simplified Procedures.
- The framework outlines a comprehensive list of documents and procedures required for the governance aspect, with a reduced burden for the Simplified Procedures.
- According to the standardized procedure, the IM must undergo static backtesting to assess its performance, as well as continuous monitoring to identify any shortcomings. Dynamic backtesting is required to complement the static backtesting process, and it must be run continuously. The results of the dynamic backtesting need to be published at the end of every quarter.
- For counterparties in the scope of the Simplified supervisory procedures, only the dynamic 1-day backtesting will be required.
Focus on the backtesting requirements
- Static backtesting:
– Involves comparing the initial margin against changes in market value, calculated by applying the returns of the risk factors used in OTC derivatives pricing.
– The overshooting of the Initial Margin, as well as counted and netting sets, are classified using specific Basel traffic light categories, based on a normal distribution methodology. This methodology assesses whether the initial margin adequately covers theoretical losses.
- Dynamic backtesting:
– Involves comparing the initial margin calculated for a 1-business day Margin Period of Risk (MPoR) against the daily market data changes between each valuation date within the period and its subsequent business day.
– The backtesting period refers to the most recent 250 days or the most recent dates available.
– The overshooting is counted for the static backtesting, and a similar classification method has to be used.
– The same pricing methods as those used for official validation must be applied in the computation of market data changes; however, a close approximation (Taylor expansion) can also be used.
- As a new addition, margin average shortfall measures and margin average relative shortfalls will be calculated for both static and dynamic backtesting.
“This Regulation shall enter into force on the twentieth day following that of its publication in the Official Journal of the European Union.
The standardized supervisory procedure shall be applicable one year from that date, while the simplified procedure shall be applicable two or three years after, depending on the Aggregate Average Notional Amount (AANA).
This Regulation shall be binding in its entirety and directly applicable in all Member States.”
As a Result…
As per the publication “The RTS on the validation of internal margin models are an important step in improving the accuracy, relevance, and effectiveness of initial margin calculations across the EU…” and “contribute to creating a level-playing field in initial margin calculations, whilst duly taking into account operational impacts.”
From a system perspective, the backtesting function now plays a new and instrumental role and is optimally implemented in a consolidated middle-office and risk platform.