Bank of England warns that some firms may be systematically under-margined for UMR

In a review letter, the Bank of England’s Prudential Regulation Authority discussed issues related to SIMM calculations and the impact the upcoming regulation will have on hedge funds portfolios.

The Bank of England’s Prudential Regulation Authority (PRA) highlighted issues related to Standardised Initial Margin Methodology (SIMM) model governance and firms’ capabilities to identify and remediate model underperformance.

The review comes in light on the upcoming UMR Phase 6 deadline on 1 September, impacting the largest amount of buy-side firms thus far.

“In our view, the existing governance process, in which firms rely primarily on the International Swaps and Derivatives Association (ISDA) for updating SIMM or negotiating add-ons for model underperformance, may result, for some counterparties, in margin levels not adequate to cover for risks at the 99% confidence level as required by regulations,” said the PRA in its review letter. 

Two areas of potential concern were highlighted by the PRA in its review. Firstly, several limitations related to 3+1 back-testing – a historical methodology introduced by ISDA as the main performance metric for SIMM – were identified. Namely, the usage of in-sample data as well as limitations related to not accounting for non-modelled risk factors in the testing process.

As a result of these limitations, PRA has suggested that 3+1 may not always adequately identify poorly-performing models, as required by the Regulatory Technical Standards (RTS). The regulator noted that in instances where the 3+1 performance measure is unsatisfactory, the resulting initial margin (IM) may not be sufficient to cover for risks at the 99% confidence level as required by the RTS for some counterparties.

The PRA also observed that firms’ primary reliance on the global ISDA governance process for updating SIMM or negotiating add-ons, may not be sufficient to ensure timely action is taken to remediate model underperformance – which is fundamentally firms’ own responsibility under the RTS.

“These findings are not related to the specifics of the model design, such as a calibration methodology which is relatively less sensitive to current market data. Our primary focus is to ensure that in-scope firms are adequately margined (in the sense specified by the RTS) on an individual portfolio basis and that they are meeting the requirement of the RTS,” added the PRA.

Impact on hedge funds portfolios

As the approaching UMR phase 6 deadline looms, more hedges funds than ever before will be brought into scope for the regulation. The PRA stated that “these funds may have portfolios with risk profiles significantly different from those to which SIMM has to date been applied. These portfolios may also be significantly exposed to risk factors not directly modelled in SIMM, due to overall materiality.”

The PRA observed that under existing practices by firms using SIMM, back-testing exceptions are considered for remediation – either by firms applying IM add-ons or by ISDA changing SIMM – only if the model shortfall exceeds a large absolute threshold. Another observation was the 3+1 back-testing is usually insensitive to non-modelled risk factors.

“This means that, without firms taking action, some portfolios will risk being systematically under-margined, for example where the overall shortfall is below the ISDA materiality threshold and/or the underlying risk factors are not modelled in SIMM,” noted PRA.

Concluding its review letter, the PRA said it expects to see evidence that the risk of under-margining is being addressed by individual firms through a self-assessment as well as by providing a corrective action plan for any gaps identified by the assessment.

In response to the letter, an ISDA spokesperson told The TRADE: “The ISDA SIMM performed robustly during the COVID crisis and the extreme volatility caused by Russia’s invasion of Ukraine, with no widespread and material instances of under-margining reported by its wide universe of users. We continually review the SIMM methodology and governance, and the methods we use to assess the performance of the ISDA SIMM meet requirements across regulatory jurisdictions. We look forward to further engaging with the UK PRA to address its concerns.”