The document discusses the potential integration of stressed value-at-risk (SVaR) into central counterparty (CCP) risk management frameworks. SVaR requires calculating value-at-risk using parameters from historical periods of financial stress. It has been adopted in Basel regulations and considered by European regulators for use in CCPs. While SVaR may help reduce procyclicality, its use for CCPs could increase clearing costs and skew default waterfalls towards a "defaulter pays" model by raising capital requirements. The document considers alternatives like using SVaR as a secondary margin or stress requirement rather than incorporating it directly into initial margin.

1. New Stress Margining for
OTC Derivatives
www.catalyst.co.uk
November 2012
Context
Although debate continues as to its conceptual
soundness and proper place in the risk
management framework, “Stressed VaR”
(SVaR) has been a reality for Banks since the
arrival of Basel 2.5 at the end of December
2011. Its purpose is ostensibly to function as
one of a series of new risk measures, designed
to address the perceived shortcomings of VaR.
Under the Basel 2.5 rules, banks must take the
standard Basel VaR parameters (99%
confidence interval, 10 day holding period) and
apply them to the most relevant 12 month period
of financial distress for the portfolio in question.
This ‘stressed’ VaR then becomes an add-on to
the standard, VaR determined, RWAs for Market
Risk.
ESMA, similarly grappling with how to address
the shortcomings of VaR, included a
requirement within the ‘Consultation Paper on
Draft Technical Standards’ that CCPs base their
Initial Margin on the weighted average of the
current VaR (or equivalent) and the VaR for the
most volatile period observed in the past 30
years. This provision has some clear parallels
with the SVaR requirements for Banks.
However, in their most recent Impact
Assessment, ESMA have stepped back from
this proposal, suggesting instead that lookback
periods for Initial Margin calculations should
instead be extended to include the most recent
market stress.
Whatever the final outcome, it seems possible
that the existing distinction between Initial
Margin as a ‘business as usual’ resource, and
mutualised Clearing Funds as a ‘stress event’
resource will be breached. As such, CCPs
should consider the impact this may have on the
structure of their Default Waterfalls, and the

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boundary between defaulter resources and
mutualised resources.
SVaR – The Positives
SVaR represents a novel use of a methodology
designed for business as usual conditions, now
applied in the context of stressed market
conditions. As such, it sits awkwardly between
standard VaR and Stress Testing, more
conservative than the former, but not as robust
as the latter. However, SVaR has some potential
uses for risk managers:
 Reducing Procyclicality – A key
motivator for the regulators, the use of
SVaR as a component of Initial Margin
would smooth the large variances in
Initial Margin levels which can occur as
volatility increases/decreases.
 Liquidity Planning for Banks – As
more of the OTC world is subjected to
CCP Clearing, the potential liquidity
requirements arising from CCPs in a
stress event is an increasing concern.
An ‘information only’ SVaR metric would
give an indicator to banks as to the
potential liquidity drain in a stress event,
assisting in their planning.
SVaR – The Shortcomings
Theoretically SVaR is an affront to
mathematicians, but putting all issues of
conceptual soundness to one side, SVaR also
poses some additional challenges for CCPs and
Market Participants:
 Higher Cost of Clearing - the
introduction of stress metrics into Initial
Margin will ultimately increase Initial
Margin, resulting both from larger
market moves and the differing
correlations which occur under stressed
market conditions. Under the original
ESMA proposal, an extraordinary bout
of volatility could drive Initial Margin
levels higher for the following 30 years.
This will inevitably increase the cost of
clearing, particular for Clients, who tend
to have more directional positions.
 Handling of New Stress Events -
under ESMAs original proposal, a new
stress event more extreme than any
witnessed in the past 30 years may be
captured more slowly in margining - as a
result of the averaging with the previous,
less extreme, stress event.
 CCP Default Waterfalls skewed to
‘Defaulter Pays’ – CCP risk frameworks
can be characterised as either ‘defaulter
pays’ where Initial Margin levels are set
to a very high confidence interval, or
‘survivor pays’ where Initial Margin
levels are set at a more moderate
confidence interval. The introduction of
stress conditions to Initial Margin skews
any model further towards a ‘defaulter
pays’ position by effectively increasing
the confidence interval covered,
potentially diminishing the resilience of
mutualised resources.
Integrating SVaR into CCP Risk
Management
In addition to the proposals set forth by ESMA,
there are a number of additional ways in which
SVaR could be integrated into CCP Risk
Management which merit some further thought
from CCPs and Regulators:
 A Measure of the ‘Pro-Cyclical Gap’ –
SVaR can provide an estimate of the
increases in Initial Margin which may be
observed in future stress events. This
‘procyclical gap’ between current Initial
Margin levels and those likely to be seen
in stressed market conditions is useful
contextual information to CCPs,
Clearing Members and Regulators.
 A Secondary ‘Stressed Margin’
Requirement – Rather than
incorporating SVaR directly into Initial
Margin, CCPs could consider
establishing a two-tier Initial Margin
requirement, with the potential for
differing collateral arrangements
between Initial Margin and ‘Stress
Margin’.
 A Secondary Clearing Fund
Requirement – To preserve the notion
that stress events should be covered by
mutualised resources, CCPs could
consider the introduction of tiering of the
Clearing Fund, again with the potential
for different rules governing the two
tiers.

3. © Catalyst Development Ltd 3
Disclaimer: Comments in this presentation on are based on Catalyst's understanding of the global regulatory landscape as of
November 2012. This document is neither intended to be comprehensive, nor to provide legal or accounting advice.
Conclusion
It seems possible that regulations in Europe will
introduce SVaR, or some analogous measure
such as longer lookback periods, into the risk
framework for CCPs. As SVaR is now an
established regulatory risk measure for their
Bank Clearing members, CCPs should consider
how SVaR may be incorporated into their own
risk framework, and ultimately how it may affect
the balance of their Default Waterfall.
It is also important to recognise that the use of
VaR by CCPs differs from other users. There is
a tendency for CCPs to be more conservative
and hence a conceptually odd method such as
SVaR may be a prudent and pragmatic solution.
Although Catalysts supports ESMA’s desire to
improve the resilience of CCP margining, further
thought is required as to the appropriateness of
SVaR as part of the CCP risk management
framework in light of the current distinction
between ‘business as usual’ risk and ‘stress’
risk, and potential impact on confidence intervals
for VaR.
Meet our authors
christianlee@catalyst.co.uk damonbatten@catalyst.co.uk
Damon Batten
Damon is a risk
specialist with
experience and strong
knowledge of traded
and non-traded market
risk, CCP clearing and
current regulatory
initiatives, including the
FSA’s ILAA regime,
Basel 3, European
Market Infrastructure
Regulation and Dodd-
Frank.
Christian Lee
Christian is Head of
our Clearing, Risk and
Regulatory Practice
and one of the world’s
most experienced risk
management
professionals. He is a
specialist in OTC
clearing, market and
credit risk, financial
markets, middle office,
APAC and Latin
America.
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