ISDA panel explores report recommending liquidation horizon changes

The International Swaps and Derivatives Association on Thursday published an academic paper recommending that the liquidation horizon for noncleared derivatives should be based on the size of a position in relation to an asset’s market depth. The paper was a key topic during a panel discussion at the ISDA Annual General Meeting in Miami on Wednesday.

Panelist Rama Cont, chair of mathematical finance at Imperial College London, is the author of the paper. He said the research seeks to make the point that regulators should weigh a position’s liquidity risk in setting liquidation horizons rather than simply setting a horizon that lasts a fixed number of days. Some noncleared trades might be feasible to liquidate within a few days, while the current 10-day horizon might be too short for a much larger position on the same contract, Cont said.

The paper also recommends changes in how initial margin is calculated for noncleared derivatives. Cont outlined a two-step calculation: First determining the exposure of the initial position until hedging takes place, followed by the exposure to the hedged position from the hedging date through the liquidation date. The current calculation is based on the exposure of the initial position over the complete liquidation horizon.

Other panelists said the paper’s recommendations would help better reflect what happens in reality.

“Very few defaults actually come out of the blue,” and major dealers examine portfolios considered to be at risk and consider the consequences if they would have to close out, said ISDA Chairman Eric Litvack, who is managing director and head of regulatory strategy at Societe Generale Global Banking and Investor Solutions.

Bruce Tuckman, chief economist of the Commodity Futures Trading Commission, said he appreciates the paper’s emphasis on liquidity. “I would prefer lots of models and lots of approaches,” he added, because “the world is a complex place” and “and it’s very hard for one model to catch everything.” He noted that Basel III, however, appears headed in the direction of more standardization in terms of models.

Darcy Bradbury, a board member of ISDA and managing director at D. E. Shaw & Co., said the current regulatory processes regarding margin requirements seem to have been developed relatively quickly and “during a time of stress,” in the wake of the 2008 financial crisis. More data is available now, however, and regulators should review whether the rules do enough to reduce systemic risk, she said.