The GFC’s butterfly effect

The Global Financial Crisis highlighted a number of vulnerabilities and exposed excessive risk taking, ultimately at the expense of members and customers, where the majority of market participants did not appreciate the interrelatedness and systemic exposure in their portfolios and businesses. Since then, regulation, oversight and controls have been refined. However, the superannuation industry is about to experience another wave of regulatory implementation that will put their operating models to the test.

OTC Trading and Counterparty Risk

Over-the-Counter (OTC) trading pre-dates all formal exchanges, where a trade is privately negotiated between two parties. This has often led to tension where one party feels that they have secured a good outcome as events unfold and the counterparty experience a sense of regret in a zero-sum game. This is particularly true in the derivative market, as there is often a time lapse between entering the derivative contract and settlement, and dates back to ancient civilisations[1]. Over the years, the OTC market grew exponentially as it enabled the transfer of risk between a willing buyer and seller and so became a foundational element for the current financial markets. As long as both parties honoured the settlement of the transaction, markets continued to operate. The challenge occurs when a party reneged on their commitment, usually when they are ‘out of the money’, leaving their counterpart exposed to the risk of a loss as a result of the default.

The introduction of exchanges has mitigated default risk as trades are novated and the exchange becomes the counterparty to both sides of the trade. Assuming the exchange can absorb any losses from defaults, it can continue to honour the other side of the trade and maintain efficient markets.

How do exchanges protect themselves from losses due to defaults?

Exchanges expect the market participants using their platforms to provide margin, which provides protection for the exchange (and market participants using the exchanges) as the expectation is that the margin is sufficient (or close to it) to cover adverse market movements.  However, this requires frequent monitoring and margin variations to ensure that the exchange is not over exposed to the counterparty defaulting.

Unfortunately, such margining practices for OTC derivatives were not that common, as OTC derivatives have generally been privately negotiated between two parties and the operational complexity of monitoring and operating frequent margin exchanges between parties have been too cumbersome.

Exchange traded contracts are generally standardised to ensure there is a sufficient demand and a viable market. On the other hand, OTC trades are often larger in size and bespoke between the counterparties based on their specific requirements. This has led to large OTC contracts being entered into and during the GFC significant numbers were defaulted on. Exacerbating this was the reality that as there were predominantly no margin posted, the ability to recover losses was compromised. As a result, in 2009, the G20 initiated a reform program to mitigate the systemic risk from OTC derivatives[2].

Margin requirements for non-centrally cleared derivatives

The G20’s reform program consisted of four initiatives[3], namely:

• All standardised OTC derivatives should be traded on exchanges or electronic platforms, where appropriate

• All standardised OTC derivatives should be cleared through central counterparties

• OTC derivatives contracts should be reported to trade repositories

• Non-centrally cleared derivatives contracts should be subject to higher capital requirements

This was followed by a further G20 agreement to extend the reform program initiatives to include margin requirements for non-centrally cleared derivatives. The Basel Committee on Banking Supervision (BCBS) and the International Organization of Securities Commissions (IOSCO) were tasked with developing global standards for these margin requirements. BCBS and IOSCO developed an implementation framework[4], requiring covered entities to comply with the new requirements, being phased in progressively from 2016-2020, based on the scale of their exposure, from the largest first[5].

APRA has adopted these standards, which forms the basis for Prudential Standard CPS 226 Margining and risk mitigation for non-centrally cleared derivatives[6]. CPS 226 applies to:

• Authorised deposit taking institutions;

• General Insurers;

• Life Insurers; and

• Superannuation funds.

Prudential Standard CPS 226 Margining and risk mitigation for non-centrally cleared derivatives formalises the requirement for APRA covered entities to have appropriate margining practices in place in relation to non-centrally cleared derivatives. APRA regulated entities that exceed the assessment threshold, are therefore required to post and collect initial margin and subsequently exchange variation margin.  

If these standards were implemented in 2016, why are they only now relevant for superannuation funds?

The reason is the tiered approach to assessment with thresholds set out in table 1 below:

Table 1 – Implementation timetable for initial margin requirements

The largest funds in Australia could trigger the $75bn threshold requiring compliance by 1 September 2021, whereas most of the medium sized funds will trigger the $12bn threshold requiring compliance with the Standards by 1 September 2022.These implementation dates were delayed from the original schedule due to the COVID-19 pandemic. Previous thresholds were too high to capture these funds, and largely aimed at the global investment banks. A similar timetable exists for the implementation of variation margin requirements.

Once compliance has been established, how is margin to be posted and received calculated?

SIMM or Standardised Schedule

As part of the CPS 226 Prudential Standard, APRA provides a standardised schedule for calculating initial margin as well as a standardised schedule for risk-sensitive haircuts[1]. This is very similar to the concept of a standard model under Solvency II. As with Solvency II, covered entities have the option to utilise an alternative model approach but must seek APRA approval in order to do so.

The ‘ISDA SIMM model’ is such a model and is an industry standard initial margin model developed by ISDA (International Swap and Derivative Association) to determine the value at risk of the open positions in a derivative contract, and which considers the requirements prescribed by the global regulators. The model was developed to provide the industry with a common methodology and therefore more transparency in dispute resolution.

ISDA published an ISDA SIMM Governance Framework in September 2017[2], outlining the principles under which the ISDA SIMM model will operate and the processes through which it will be reviewed and amended on a consistent and transparent basis.

Once the calculation methodology is established what does this mean for the covered entity’s operating model?

Collateral Optimisation

Covered entities can separately run their margin requirements, securities lending and portfolio construction (and potentially outsource some of these functions).  Alternatively, the organisation can integrate these capabilities to facilitate the creation of a collateral optimisation program. By having clarity on which securities should be available for portfolio construction, the organisation can determine which securities are available for the posting of collateral and margin to meet the margin requirements plus what is available for lending. These programs would see superannuation funds optimising their asset base in members’ best financial interests. This avoids the risk of being perceived as contributing to market speculation, which comes from standalone security lending programs. Underpinning the success of such a program is the integration and scalability of the organisation’s solutions and functions.

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