Initial margin is now more important than ever to participants in the over-the-counter derivatives markets because it touches many areas of the transactional process including marketing, credit, legal, operations and funding.
I. What is initial margin?
As its name suggests, initial margin is collateral that is posted at the outset of a derivatives transaction. It is generally sought by market participants as an extra cushion of support to protect against unexpected credit and operational risks. These risks can include problems such as operational error, large swings in market value and delays in calling for or receiving collateral. Initial margin is requested primarily from firms at the lower end of the credit spectrum.
Initial margin is also referred to as initial collateral or the initial collateral requirement. Another common term is independent amount, which is used in the International Swaps and Derivatives Association Credit Support Annex, the industry's standard collateral agreement. A new term about to enter the collateral lexicon is additional protection amount, which appears in the proposed revision of ISDA's agreement.
Initial margin is often only one component of the total collateral requirement. The other component is commonly referred to as the variation margin, which is the amount of collateral required to cover the credit risk relating the entire portfolio of transactions between the trading parties. The variation margin takes into account netting of the market values of the individual transactions and is based on the concept of replacement value (i.e., the losses that would be incurred if a third party assumed the payment obligations of the defaulting party).
Under this framework, then, the total collateral requirement on any given day is the sum of the variation margin and the initial margin requirements for each of the transactions.
To fulfill this collateral requirement, various types of collateral are pledged. In the U.S., common forms are cash, U.S. Treasury and agency securities, equities, mortgage-backed securities and other marketable securities. Outside the U.S., common forms are local currencies and government securities.
Initial margin can be structured in different ways, depending on the types of transactions involved and the level of credit protection sought. Examples include a fixed dollar amount; a fixed percentage of the notional amount of a derivatives transaction; a fixed number of shares of a specific issue of common stock; fixed dollar amounts that decline in a stair-like fashion over time. Other examples are amounts based on variables, such as years remaining in a transaction; amounts that take effect only upon the occurrence on certain credit events, such as change in capital, covenant defaults and ratings downgrades. Finally, initial margin could include amounts that may grow or contract on any given valuation day, depending on the amount and direction of the replacement value of the portfolio of transactions between the parties. This takes into account the effects of any netting (this concept is commonly known as rebate of initial margin).
II. Why is initial margin an important credit management tool?
Collateral is now used more frequently by market participants to manage unexpected credit deterioration. The value of collateral (or the risk of trading without it) has been well demonstrated during several instances of significant credit deterioration. The most notorious example is the Russian default and the collapse, or near collapse, of several large hedge funds. Another noteworthy example is the turmoil in the U.S. electricity market during the summer of 1998, appropriately named "Bloody Summer" because of some large defaults among power marketers.
Initial margin has primarily been used with hedge funds, non-investment grade entities, real estate partnerships, thrifts and highly leveraged entities.
The argument for using initial margin is that the variation margin may not be sufficient to cover credit losses under unusual market or credit conditions. There are, moreover, many sources of operational error that can delay or reduce the amount of collateral requested or pledged. Even in the absence of operational error, there is often a lag between the time the collateral is first called for and the time that the collateral holder can liquidate the collateral and apply the proceeds to cover credit losses. In certain cases, this delay can be five business days or more, depending on the terms of the collateral agreement and other complicating factors. Some firms determine the amount of initial margin based on an estimate of the five-day movement in the transaction's market value.
In the wake of the losses related to the Russian default and other credit migrations, it appears that firms which obtained initial margin made sound credit decisions; firms that shunned initial margin could arguably be viewed as unduly liberal.
The report of the United States General Accounting Office on the hedge fund Long-Term Capital Management noted that dealers provided the fund "favorable credit terms" for its derivatives transactions, including the absence of initial margin. The Basel Committee on Banking Supervision reported earlier this year that banks are now requiring greater initial margin with highly leveraged institutions.
III. How is the documentation for initial margin organized?
The documentation of initial margin often involves three interrelated contracts: the confirmation for the transaction, the collateral agreement and the master agreement.
The actual amounts of initial margin amounts are typically described in the confirmation, which is generally sent by the dealer shortly after the transaction is executed. The collateral agreement contains provisions, such as the type of eligible collateral, delivery mechanics, collateral reuse (or prohibition), custody requirements, security perfection provisions and other relevant legal and operational provisions.
The confirmation and collateral agreement are often used in conjunction with the ISDA Master Agreement, which includes events of default, netting provisions, damage calculations for defaults and other credit and legal provisions.
IV. What credit and operational risks can arise with initial margin?
Various issues unique to initial margin can create problems. The key challenge is that initial margin has to be determined, communicated, documented, processed and monitored for each transaction. There are, accordingly, many opportunities for error before, during and after a trade.
Problems can arise in pre-trade communication (both internal and external) transaction execution, confirmations, collateral calculations and management reporting. There are, moreover, other issues that can complicate initial margin.
Often many participants are involved, including credit officers, marketers, confirmation specialists, lawyers and collateral units. For valid reasons, many organizations produce the confirmations out of one unit and the master agreements and collateral agreements out of a different unit.
The total collateral requirement is often described in the confirmation and the collateral agreement. The language in the confirmation may supplement or modify the language in the collateral agreement.
Some transactions may only require initial margin and therefore the variation margin will play no role in the collateral calculations. Accordingly, the confirmation may require a provision to suppress the requirement for the variation margin relating to transactions. This is often the case for certain types of equity derivatives transactions where the initial margin is a fixed number of equity shares calculated to cover the total maximum credit risk of the transactions.
Some initial margin amounts are reduced or increased, as the case may be, based on the change in the direction and amount of the replacement value of the derivatives transactions. These calculations, which are commonly known as rebates, can be a significant source of confusion, particularly if the practice varies among different counterparties.
For some counterparties, some transactions may require initial margin and some may not. Confusion can arise over which choice is applicable for any given transaction.
V. What steps can prevent problems with initial margin?
Problems with initial margin can be prevented. As a general matter, firms should create a high level of clarity in the collateral process and promote fluid communication among transaction participants. A number of specific steps are also essential.
The initial margin for each transaction should be communicated to the counterparty before trading and the counteparty should confirm this understanding.
The initial margin should be clearly and accurately set forth in the confirmation (or other place, to the extent appropriate). Confirmations should be sent to the counterparty as soon as possible and followed up promptly if not acknowledged. In addition, the collateral unit should be advised of any transactions that require initial margin; any systems data or collateral calculations must be adjusted accordingly.
The relevant features of the collateral agreements should be summarized and easily available to all relevant participants in electronic form. This includes the type of collateral agreement, status, potential for initial margin, rebate provisions, collateral reuse, types of eligible collateral, haircuts, trigger events and any other critical features.
The legal, operational and systems implications of any new initial margin structure should be vetted and understood by all participants. Initial margin activity should be reconciled promptly following trading. Actual amounts of collateral received or provided should routinely be compared to the collateral requirements.
A sound collateral process for initial margin (or any kind of collateral) involves many elements. The more complicated the process becomes, the greater the potential for malfunction or error. If something can go wrong, it probably will; and it may do so just when firms need it to work well.
To prevent problems with initial margin, firms need to be commercially reasonable, organized, rigorous and vigilant--before it's too late.
This week's Learning Curve is written byCharles A. Fishkin, a New York based consultant with a special interest in credit and operational risk (firstname.lastname@example.org).