European energy traders could face margin hikes of up to 80% as a new calculation model takes effect.
The risk weighting of European energy derivatives has jumped under the latest version of the Standard Initial Margin Model, which is used to calculate initial margin for uncleared derivatives.
Firms need to post collateral on trades to ensure they complete the transaction. The new version of Simm upped the risk weight of European energy derivatives by 80%, a change that will also affect existing contracts.
Simm is revised every year. The latest version, 2.5, came into effect on 5 December.
The changes will lead to major increases in margin if a portfolio is exposed to commodities. According to research firm Clarus, in a hypothetical portfolio of various North American and European energy derivatives, margin requirements would rise by 36%.
Spikes earlier in the year in energy prices already hit cleared and exchange-traded derivatives. But margin requirements for uncleared derivatives have lagged behind because Simm is only revised yearly.
A spokesperson for the International Swaps and Derivatives Association, which calculates Simm, said: “Given increased volatility in commodities markets, the margin amounts calculated through Simm would be expected to increase.
“As part of the ISDA governance framework, a quarterly review is conducted to determine if there is any need for an early recalibration of Simm to take place. For the regular annual and any early recalibration, market participants are generally aware of any changes several months in advance, so have time to prepare.”
How much additional margin firms will need to pay depends on multiple factors. Most firms will have offsetting positions, or a diversified portfolio that will include contracts in other asset classes allowing them to net off their collateral requirements.
Few firms will see the full 80% increase in collateral, said Jo Burnham, risk and margining expert at OpenGamma, a collateral management firm.
“The 80% margin only occurs if your portfolio is solely European gas and energy contracts. If you’ve got a more mixed portfolio it is going to be lower than that,” she said.
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While many large banks have trimmed their commodity trading books, some smaller asset managers who recently fell under the scope of uncleared margin rules also have exposure to the commodity markets.
Those who otherwise might have stayed below the rules’ $50m threshold may now also need to post margin with a custodian bank.
“Firms might want to reconsider how they rebalance their portfolio, especially if they’re considering their threshold,” said Siti Eschrich, global product manager for collateral solutions at Bloomberg.
In August and September, during increased volatility in European energy markets, margin requirements for cleared energy products were also as high as 80-90%, said Tobias Davis, head of liquefied natural gas for Asia at Tullett Prebon.
“It impacted everyone in the marketplace. Position readjustment was happening at pace.”
In the months after Russia’s invasion of Ukraine, the European Central Bank found some firms moved away from trading cleared contracts towards uncleared derivatives. Collateral requirements rose so quickly that European governments had to help firms meet the higher margin calls.
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The market has since calmed. Davis said margin for energy is now around 20-30%, depending on the product.
“The cleared margins have been raised considerably, but are now falling as gas prices are slightly more stable,” said Nicholas Fentem, head of post-trade solutions at TP ICAP. “It may become more efficient to go into cleared products because Simm is rising while cleared is falling.”
The next Simm revision could have an even bigger impact. Version 2.5 covers 2019 to 2021. Version 2.6, would include this year’s market volatility from the war in Ukraine and the rapid rise of interest rates in advanced economies.
“In terms of interest rates, there’s been no impact in this period for Simm. But when they update it for next year I would assume to see a significant increase for interest rate risk,” said Fentem.
To contact the author of this story with feedback or news, email Jeremy Chan