After more than 30 years, the Chicago Mercantile Exchange (CME) is deprecating SPAN and instituting SPAN2, effectively adopting a historical Value at Risk (HVaR) methodology to calculate the performance bond or initial margin (IM) requirement of a portfolio. The exponential growth in tradeable products, coupled with the market velocity witnessed in recent flash crashes, has raised concerns if traditional IM methodologies like SPAN are sufficient. Regulatory agencies are pushing central counterparties (CCP)s to reassess their risk management practices. Recommendations include reduced cadence in CCP risk review of margin risk parameters, calculation of requirements intraday to account for market movements, and institution of anti-procyclicality margin measures. Analysis reveals CCPs are proactively implementing regulatory recommendations along with concentration and liquidity risk add-ons within models.
CME’s methodology migration will bring listed derivatives under the same model employed with the exchanges Over-the-Counter (OTC) Interest Rate Swaps and Foreign Exchange product sets. Scheduled to be phased in over several years starting with energy products, SPAN2 will use historical data to model gains and losses, coupled with stress risk, liquidity risk and concentration risk factors. As the breadth and complexity of products listed by large CCPs has grown, market participants have identified growing pains with SPAN, most notably with cross-product correlations. The benefits of CME’s historical VaR approach are correlations that are inherently included, anti-procyclicality is addressed with volatility floors, while cross-margin relief can be tailored per product set.
The CME is not the only CCP migrating to a VaR approach for calculation of IM, ICE and LME are also planning or underway with migrating product sets of their markets to HVaR methodologies. However, the exchange’s announcement may be the impetus of an unintended disruption. The exchange has confirmed its commitment to maintain SPAN, which is the most widely employed methodology for calculating margin and assessing risk across numerous types of financial instruments, currently licensed and utilized by 32 exchanges and countless clearing members, banks, funds, brokerage firms and risk managers globally. Regardless, we are at an inflection point where those exchanges currently utilizing SPAN are likely to reassess their risk management processes and methodologies, potentially fracturing the dominance of CME SPAN. In time, we will learn if CME maintains the inertial force to position SPAN2 as the de facto replacement and industry standard IM methodology. With any number of the numerous exchanges currently licensing CME SPAN potentially electing to license another exchange methodology or implement their own model tailored to the nuances of their markets, the magnitude of this disruption will be significant; impacting the clearing members, banks and brokerage firms of numerous exchanges and all those market participants downstream. While the explosion in tradeable products and risk factors add-ons to existing margin models created challenges for primarily vendors, the shift to employ a new model presents challenges to the entire industry.
These challenges include not only maintaining IM calculations aligned with all the CCPs and exchanges, but as traded volumes and algorithm complexity grow, ensuring the technological solutions have sufficient capacity for intraday and end-of-day calculations. Firms will require the capacity to replicate SPAN2 methodology to calculate requirements at the individual account level and calculate client margin calls. The CME methodology migration will require CME-specific adoption and integration to meet the requirements of the current solution. This means development and integration efforts coupled with management of numerous risks related to the technology, methodology and operational changes. As more exchanges migrate to VaR methodologies, the effort to integrate and maintain discrete margin engines or connectors per a CCP increases exponentially. Operational expense is another ongoing consideration, as additional resources are required to ensure quality assurance for new releases per an exchange to ensure there is no unexpected behavior. In some instances, firms have the option to connect to third-party sources, like the CCP. However, this approach introduces an additional set of challenges and concerns. Firms must weigh the risk and impact of potential of unanticipated latency. Lack of support managing breaks, errors, or service interruptions and issues is an operational and risk concern. And anytime data travels outside the existing firewall, data security is a critical factor, especially when transmitting portfolios and other customer or house data over the internet. To address these new market challenges, FIS designed FIS Cleared Derivatives Margin Advisor, which ensures integrity and simplifies maintenance of margin calculations.
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Looking forward we expect regulatory pressures to increase and exchange trends to continue. Exchanges and CCPs will continue taking steps to better align risk cost to risk taker which reduces market risk. While it remains to be seen if SPAN2 retains the dominance of SPAN, the complexity and technological requirements of maintaining CCP IM methodologies will grow. Margin Advisor provides all cleared exchange market participants with a solution that consolidates technology requirements and ensures IM calculations are aligned with the exchanges. Margin Advisor is designed to optimize performance to meet capacity even on X-factor days. Leveraging Margin Advisor either on-premise or via SaaS model allows firms to reduce their total cost of ownership and allocate their resources toward efforts that differentiate their business.
Margin Advisor is a module of FIS Cleared Derivatives, a suite of solutions based on modern technology, providing integration, automation and real-time transparency to increase operational efficiency, mitigate risk and reduce cost of ownership.