Risk Analyst Says New Margin Models Are Better but Less Transparent
Commentary by Steven Lofchie
The Futures Industry Association ("FIA") published an analysis on the evolution of the methodology used by central clearinghouses for the purpose of calculating margin for exchange-traded derivatives.
In an FIA "MarketVoice" article, titled "Navigating a New Era in Derivatives Clearing," the author described the transition in the global central counterparty landscape from the Standard Portfolio Analysis of Risk ("SPAN") models to Value-at-Risk ("VaR") models. He stated that this transition was "driven by the need for more dynamic and comprehensive risk assessment tools." He said that SPAN models are easier to understand and use, as they measure risk at the product level and presumably then aggregate the risk across products. By contrast, VaR models are intended to measure risk across a portfolio of positions as a whole, and to take account of "the effects of hedging, diversification and cross-correlations" between different products.
The author states that the VaR models should generally be more accurate as to markets characterized by "rapid change and volatility," but notes a variety of difficulties with these models, including reduced transparency as to the reasons for the results, given that those results depend upon "computationally intensive" algorithms analyzing the interactions between a variety of products. He concluded that the industry "faces the dual challenge of embracing innovation while ensuring financial stability and systemic resilience."
Commentary
The discussion of the margin models is in many ways similar to the debate over the uses of artificial intelligence for a number of purposes, including credit scoring. That is, the end product seems to be better, but we don't know exactly why we got that result. At least as to central clearing, this may present a practical difficulty for clearing members: How much liquidity do clearing members need to set aside to meet margin calls when the amount of the call is not readily predictable?
As the industry moves to central clearing of U.S. government securities as mandated by the SEC, one of the concerns expressed by the industry is whether the amount of margin calls made by the FICC will be predictable and transparent to clearing members. Presumably, the margin methodology to be used by FICC will be among the issues to be discussed as FICC puts forward the necessary rule changes to make effective the SEC's central clearing mandate.