Element 3: Baseline Minimum Amounts and Methodologies for Initial and Variation Margin

Effective from 2020-10-05 - Oct 04 2020
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The methodologies for calculating initial and variation margin that serve as the baseline for margin collected from a counterparty should (i) be consistent across entities covered by these requirements and reflect the potential future exposure (initial margin) and current exposure (variation margin) associated with the particular portfolio of noncentrally cleared derivatives at issue and (ii) ensure that all counterparty risk exposures are covered fully with a high degree of confidence.

14.

The applicable netting agreements in these requirements are not allowed in Saudi Arabia until relevant laws are enacted and netting is allowed by SAMA. If netting is enforceable in any jurisdiction, positive and negative mark to market exposures in that jurisdiction will be allowed to net.

Initial Margin

15.	For the purpose of informing the initial margin baseline, the potential future exposure of a non-centrally cleared derivatives should reflect an extreme but plausible estimate of an increase in the value of the instrument that is consistent with a one-tailed 99 per cent confidence interval over a 10-day horizon,⁸ based on historical data that incorporates a period of significant financial stress. The initial margin amount must be calibrated to a period that includes financial stress to ensure that sufficient margin will be available when it is most needed and to limit the extent to which the margin can be procyclical.
16.	The required amount of initial margin may be calculated by reference to either a quantitative portfolio margin model, or a standardised margin schedule. Banks should use the standardised schedule for initial margin. If a bank wishes to use advanced models, it should be subject to internal governance process, validation, testing and approval by SAMA. Models that have not been granted explicit approval may not be used for initial margin purposes.
17.	When initial margin is calculated by reference to an initial margin model, the period of financial stress used for calibration should be identified and applied separately for each broad asset class for which portfolio margining is allowed, as set out below. In addition, the identified period must include a period of financial stress and should cover a historical period not to exceed five years. Additionally, the data within the identified period should be equally weighted for calibration purposes.
18.	Quantitative initial margin models must be subject to an internal governance process that continuously assesses the value of the model’s risk assessments, tests the model’s assessments against realised data and experience, and validates the applicability of the model to the derivatives for which it is being used. The process must take into account the complexity of the products covered.
19.	Quantitative initial margin models may account for risk on a portfolio basis. More specifically, the initial margin model may consider all of the derivatives that are approved for model use that are subject to a single legally enforceable netting agreement. Derivatives between counterparties that are not subject to the same legally enforceable netting agreement must not be considered in the same initial margin model calculation.
20.	Derivative portfolios are often exposed to a number of offsetting risks that can and should be reliably quantified for the purposes of calculating initial margin requirements. At the same time, a distinction must be made between offsetting risks that can be reliably quantified and those that are more difficult to quantify. Accordingly, initial margin models may account for diversification, hedging and risk offsets within well defined asset classes such as currency/rates,⁹,¹⁰ equity, credit, or commodities, but not across such asset classes and provided these instruments are covered by the same legally enforceable netting agreement. However, any such incorporation of diversification, hedging and risk offsets by an initial margin model will require approval by SAMA. Initial margin calculations for derivatives in distinct asset classes must be performed without regard to derivatives in other asset classes.
21.	For entities using standardised margin schedule, the required initial margin should be computed by referencing the standardised margin rates in Appendix A, and by adjusting the gross initial margin amount by an amount that relates to the net-to-gross ratio (NGR) pertaining to all derivatives in the legally enforceable netting set.
22.	The required initial margin amount should be calculated in two steps. First, the margin rate in the provided schedule would be multiplied by the gross notional size of the derivatives contract, and then this calculation would be repeated for each derivatives contract. This amount may be referred to as the gross standardised initial margin. Second, the gross initial margin amount is adjusted by the ratio of the net current replacement cost to gross current replacement cost (NGR). This is expressed through the following formula:
	Net standardised initial margin = 0.4 Gross initial margin + 0.6 * NGR * Gross initial margin*
23.	Where NGR is defined as the level of net replacement cost over the level of gross replacement cost for transactions subject to legally enforceable netting agreements. The total amount of initial margin required on a portfolio according to the standardised margin schedule would be the net standardised initial margin amount.
24.	Derivatives transactions between covered entities with zero counterparty risk require no initial margin to be collected and may be excluded from the initial margin calculation.
25.	In a case where bank is allowed by SAMA to use an approved quantitative portfolio margin model, it will not be allowed to switch between model- and schedule- based margin calculations in an effort to “cherry pick” the most favourable initial margin terms. Accordingly, the choice between model- and schedule-based initial margin calculations should be made consistently over time for all transactions within the same well defined asset class and, it should comply with any other requirements imposed by SAMA. However, a bank may be allowed –upon SAMA’s approval- to use a model-based initial margin calculation for one class of derivatives in which it commonly deals and a schedule-based initial margin in the case of some derivatives that are less routinely employed in its trading activities.
26.	Initial margin should be collected at the outset of a transaction, and collected thereafter on a routine and consistent basis upon changes in measured potential future exposure, such as when trades are added to or subtracted from the portfolio.
27.	The build-up of additional initial margin should be gradual so that it can be managed over time. Moreover, margin levels should be sufficiently conservative, even during periods of low market volatility, to avoid procyclicality. The specific requirement that initial margin be set consistent with a period that includes stress is meant to limit procyclical changes in the amount of initial margin required.
28.	Parties to derivatives contracts should have rigorous and robust dispute resolution procedures in place with their counterparty before the onset of a transaction. In particular, the amount of initial margin to be collected from one party by another will be the result of either an approved model calculation or the standardised schedule. The specific method and parameters that will be used by each party to calculate initial margin should be agreed and recorded at the onset of the transaction to reduce potential disputes. Moreover, parties may agree to use a single model for the purposes of such margin model calculations subject to bilateral agreement and appropriate approval by SAMA. In the event that a margin dispute arises, both parties should make all necessary and appropriate efforts, including timely initiation of dispute resolution protocols, to resolve the dispute and exchange the required amount of initial margin in a timely fashion.

Variation Margin

29.	For variation margin, the full amount necessary to fully collateralise the mark-to- market exposure of the non-centrally cleared derivatives must be exchanged.
30.	To reduce adverse liquidity shocks and in order to effectively mitigate counterparty credit risk, variation margin should be calculated and exchanged for non-centrally cleared derivatives subject to a single, legally enforceable netting agreement with sufficient frequency.
31.	Parties to derivatives contracts should have rigorous and robust dispute resolution procedures in place with their counterparty before the onset of a transaction. In the event that a margin dispute arises, both parties should make all necessary and appropriate efforts, including timely initiation of dispute resolution protocols, to resolve the dispute and exchange the required amount of variation margin in a timely fashion.

⁸ The 10-day requirement should apply in the case that variation margin is exchanged daily. If variation margin is exchanged – at exceptional cases approved by SAMA as prescribed in paragraph 11 of these requirements- at less than daily frequency then the minimum horizon should be set equal to 10 days plus the number of days in between variation margin exchanges; the threshold calculation set out in paragraph 12 should nonetheless be made irrespective of the frequency with which variation margin is exchanged.
⁹ Currency and interest rate derivatives may be portfolio margined together for the purposes of these requirements. As an example, an interest rate swap and a currency option may be margined on a portfolio basis as part of a single asset class.
¹⁰ Inflation swaps, which transfer inflation risk between counterparties, may be considered as part of the currency/rates asset class for the purpose of computing model-based initial margin requirements, and as part of the interest rate asset class for the purposes of computing standardised initial margin requirements.