Initial margin and the uncleared margin rules, explained

Variation margin and initial margin

Two different things get called margin, and mixing them up is the most common mistake in this topic.

• Variation margin (VM) tracks the current mark-to-market of the trades. It moves every day (or intraday) so that the exposure of one party to the other is reset close to zero. It covers the loss you have already incurred.
• Initial margin (IM) is a buffer posted up front, sized to cover the loss that could build up between the other side defaulting and its trades being closed out or replaced. It covers the loss you might incur.

Centrally cleared trades have always carried both, set by the clearing house. The uncleared margin rules (UMR) bring a similar discipline to bilateral trades that are not cleared.

Where the rules come from

After 2008 the G20 asked for stronger standards for derivatives that are not centrally cleared. The Basel Committee and IOSCO published a joint framework for margin requirements on non-centrally cleared derivatives, which individual jurisdictions then implemented through their own regulations (for example EMIR in the EU, and the rules of the US prudential regulators and the CFTC in the US). The core design is shared; details such as thresholds in local currency, scope and exemptions differ by jurisdiction.

Who has to post it, and when

The requirement was phased in by size. A firm is brought into scope when the average aggregate notional amount (AANA) of its uncleared derivatives, measured over a set period, exceeds the threshold for that phase. Under the internationally agreed schedule, as later extended by regulators:

Phases 5 and 6 pulled in many asset managers, pension funds and smaller banks for the first time. Both were delayed by a year from the original timetable. Treat the dates as a guide and confirm the exact dates and measurement periods with your own regulator.

Two limits that decide whether IM actually moves

• The IM threshold, €50 million. Measured across the trades between two groups, IM only has to be exchanged if the calculated amount exceeds this. Below it, no IM moves, although VM still does.
• The minimum transfer amount, €500,000. Transfers of VM and IM combined smaller than this do not have to be made, which avoids a stream of small movements.

How IM is sized

The framework sets the target: IM should cover potential future exposure over a margin period of risk of 10 days, at a 99% one-tailed confidence level, calibrated to a period of financial stress. Two approaches are allowed.

1. A quantitative model

Most large dealers use the ISDA Standard Initial Margin Model (SIMM), a sensitivity-based model agreed industry-wide so that both sides of a trade can calculate, and reconcile, the same number. Sensitivities (delta, vega and curvature) to risk factors are aggregated using prescribed risk weights and correlations.

2. The standardised schedule

A grid of percentages applied to trade notional, by asset class and maturity, then reduced for netting. The percentages in the Basel/IOSCO framework are:

The gross figure is then adjusted for netting using the net-to-gross ratio (NGR), the net replacement cost of the portfolio divided by the gross:

Example. A single 10-year interest rate swap with $100 million notional falls in the 5+ year bucket: 4% × $100m = $4.0m gross. With one trade the NGR is 1, so net IM is also $4.0m. Now add trades so the gross IM is $8.0m but offsetting positions bring the NGR to 0.25: net IM = 0.4 × 8.0 + 0.6 × 0.25 × 8.0 = 3.2 + 1.2 = $4.4m. The schedule is simple and conservative, which is why firms close to the threshold often prefer a model.

Where the collateral sits

IM works only if it is there when the poster defaults, so the rules are strict about custody. Collateral must be held by a third-party custodian, segregated from the holder's own assets, and may not be rehypothecated, re-used or re-pledged (apart from limited exceptions in some jurisdictions). Each side posts to the other, so IM is two-way. Eligible collateral is typically high-quality liquid assets, with haircuts applied.

Common exam and interview traps

• Calling IM a mark-to-market payment. That is VM.
• Forgetting that the €50m IM threshold and €500k minimum transfer amount are different tests.
• Dropping the 10-day horizon: IM is a 10-day, 99% stressed number even when the portfolio is liquid.
• Assuming IM can be re-used. Segregation and no rehypothecation are the point.
• Applying one jurisdiction's thresholds to a trade covered by another's rules.

More guides

• Value at Risk: the square-root-of-time ruleScale a one-day VaR to ten days with a worked example, and see where the rule breaks.
• Duration and convexity: how good is the approximation?A ten-year bond repriced at four yield shocks, exactly and with the duration and convexity estimates.
• Valuing an interest rate swap: a three-year worked exampleDiscount factors, the par swap rate and the value of a 4% swap, step by step.
• Expected shortfall versus VaR: what changes in the tailWhy regulators moved from 99% VaR to 97.5% expected shortfall, with normal and fat-tailed numbers.
• Credit valuation adjustment (CVA): a worked exampleWhat counterparty credit risk costs on a derivative, step by step from exposure, default probability and recovery.