Examining the CME IRS Margin Model Change

What does the CMEs recent change to its margin model for interest rate swaps
mean for market participants, and how might it impact CMEs market share?
CME recently made a change to its margin model for interest rate swaps see the CME
Advisory here. This explains that on Aug. 25, 2014, the model changed to use shifted log returns
from log returns. The link in the advisory further states that:
Data for each currency will be shifted by 4% before computing the log returns ... and
reflects a robust, long-term approach that yields more desirable outcomes in both low-
and high-interest rate environments.
The advisory adds: Another artifact of this change is that the margins between pay fixed
and receive fixed would become less asymmetric.
It is this last statement that really interested me, and this article will investigate the details of this
change.
Before the Change
Lets start by looking at the situation before the change, by entering into USD Par Swaps first,
a 2Y 150m and second, a 5Y 100m, for the execution date of Aug. 22, 2014.
Using Claruss CHARM, we can determine the initial margin on Aug. 22 for both paying fixed
and receiving fixed:

From which we can observe:
2Y Pay Fix IM of $775k is almost half the 2Y Rec Fix IM of $1.5m!
5Y Pay Fix IM of $1.4m is two-thirds the 5Y Rec Fix IM of $2.15m!
Both results seem surprising, so lets look at the distribution of Historical Simulation PL results,
which determine the IM, to understand why.
First, the 2Y Pay Fix:

Then the 2Y Rec Fix:

From which can observe:
Both distributions are heavily skewed.
The Pay Fix distribution has a long tail to the right, on the profit side, while the Rec Fix
distribution has a long tail to the left, on the loss side.
As IM is a loss measure, it is the left tail that is important.
And for CME 99.7% confidence level, it is the fourth and fifth largest loss scenarios that
determine IM.
These IM Scenarios are much further to the left (more negative) for the Rec Fix,
explaining why the Rec Fixed IM is much higher than the Pay Fix.
We know that a Rec Fix Swap will lose money when interest rates rise. This fact, and the above
skew, implies that the CME historical dataset contains larger positive shock scenarios than
negative shock scenarios.
In fact, were we to drill-down in CHARM, we would see that for the Pay Fix trade, the IM is
determined by the fourth and fifth largest 2Y scenarios that are -23 bps, while for the Rec Fix
trade, the fourth and fifth largest 2Y scenarios are +46 bps explaining why the margin is half
for the former.
Our intuition would then be that either the historical period (the past 5 and a half years) has more
and larger 5-day moves on the upside versus the downside for 2Y, or that some large down
moves are being discarded from the sample because of the zero floor constraint (negative
forwards).
After the Change
Lets now enter new trades on Aug. 26 with the same characteristics and use CHARM to
calculate the IM on Aug. 26, the day after the CME change went live:

Which shows:
2Y PayFix is similar to before, $700k vs $775k.
Drill-down shows that the IM scenarios (4 & 5) are now -21 bps, instead of -23 bps.
2Y RecFix is now $1.1m vs. 1.5m, so 73% of what it was.
Drill-down shows that IM scenarios (4 & 5) are now +35 bps, instead of +46 bps.
2Y PayFix at $700k is now 63% of RecFix, instead of 50%.
5Y IMs are not materially different from before.
So at least for the 2Y, we can agree with the CME statement that Pay Fix and Rec Fix are less
asymmetric after the change.
The fact that 5Y asymmetry is unchanged gives us a clue into what is happening. As 2Y rates are
much lower than 5Y rates, it is much more likely that large down scenarios are hitting the zero
floor for 2Y than for 5Y; such scenarios are then being capped, reducing the size of down moves
and resulting in some of the asymmetry. This effect is reduced with the change to using shifted
log returns with a 4% shift.
However, the fact that asymmetry remains is an artifact of the historical market moves in the past
5 and a half years.
LCH Margin
A good way to understand this is to use CHARM to run both CME and LCH margin for the same
trades:

Which shows that:
For Rec Fix Swaps, the CME and LCH margins are similar.
LCHs are 5% to 10% higher, most likely due to LCH using absolute scenarios while
CME uses relative scenarios.
However, for Pay Fix, LCH does not show the same asymmetry as CME.
Pay Fix or Rec Fix has similar IM at LCH.
Pay Fix is 80% to 90% of Rec Fix at LCH, compared to 60% at CME.
Our intuition would then be that as LCH uses a 10-year historical window (as well as absolute
scenarios), versus a 5.5 year window (and relative scenarios) at CME, this longer time period
contains a more even distribution of up and down moves.
Some Thoughts
Symmetry is a desirable property in any risk measure, including Initial Margin. While the
asymmetry between paying fixed and receiving fixed at CME has been reduced with this change,
it is still very significant and markedly so when compared to LCH.
Such asymmetry can lead to a bias in risk with potentially unforeseen and undesirable
consequences.
The fact that it is much cheaper in IM terms to pay fix at CME than to receive fix, and much
cheaper to pay fix at CME than to pay fixed at LCH, means that firms will naturally tend to
prefer to pay fix at CME.
For market participants that have a preference to pay fix (e.g., mortgage banks) or those
participants that can chose to clear on CME or LCH (e.g., large clients), there is a bias for them
to want their trades to be cleared on CME and not LCH.
As Swap Dealers are on the opposite side of this trade, they would be receiving fixed and so
suffer the higher CME margin meaning that they would expect to be compensated for this by
either offering a worse price for a CME-cleared Swap vs. an LCH-cleared one, or by other
means, such as fees.
We might even hazard a guess that one of the reasons for CME gaining market share in US client
clearing over LCH is due to the lower margin requirement for paying fixed at CME.
Summary
CME recently introduced a change to its margin model for IRS. This introduces a shifted log
returns method designed for more robust results in high- and low-rate environments.
One benefit of this change is to reduce the asymmetric margin between paying fixed and
receiving fixed. We test the before and after model and find this is indeed true for 2Y USD
Swaps but not for 5Y Swaps.
A significant asymmetry remains in USD Swaps, meaning that paying fixed at CME is much
cheaper in IM terms than receiving fixed.
The LCH margin model does not suffer anywhere near as much from this asymmetry.
Asymmetry in a risk measure is undesirable and likely to cause bias in behavior.
It may or may not be a factor in explaining the gain in CME market share in client clearing.
We expect that in future, an increase in margin for paying fixed in USD at CME will be required
to reduce this asymmetry.