Value at risk - Frequently asked questions

We've collated a list of the questions that we're being asked most often about Value at Risk (VaR) - this list will be updated and expanded frequently with new information, so please visit regularly for further developments.

Why has the LME decided to change the margin methodology?

 

Our analysis has concluded that members and clients would benefit from a custom-designed VaR margin methodology to calculate initial margin for the LME market. We outlined this in our Discussion Paper engagement process in 2017 and the feedback confirmed that members and their clients are keen for the LME to pursue VaR as part of our Strategic Pathway.

What is VaR and how is it calculated?

VaR is a widely adopted risk methodology used in many asset classes, by various central counterparties and other financial institutions. There are many different mathematical approaches for calculating VaR. In general, VaR is a portfolio-based calculation which looks to estimate the potential level of loss of the portfolio based on a set of simulations applied.

How does VaR compare to the current methodology? 

VaR is a cohesive portfolio-based methodology which seeks to reflect the potential total profit and loss of all positions within a portfolio. In comparison, the SPAN* methodology looks at combinations of positions and the potential loss of each combination individually before these are aggregated. This is less efficient, particularly for portfolios with many spread positions.

What are the key advantages of VaR?

  • Increased margin efficiencies. 
  • A custom-designed version of the methodology specifically for LME markets.
  • Automatically reflects current market conditions.
  • Takes portfolio risk composition into account.
  • Consistent with regulatory direction of travel.
  • Widely understood and adopted risk methodology. 

When will VaR be implemented?

LME Clear plans to adopt VaR margining and replace the current SPAN methodology in 2019, subject to regulatory approval. We recognise that this is a high impact, large scale project and we will be engaging with the industry, LME Clear members, Independent Service Providers (ISVs) and clients through dedicated forums, working groups and via regular ongoing updates on our website.

Who will it impact?

Introducing VaR will affect all LME Clear members and clients. We will discuss this with members, clients and their ISVs to understand the changes required to systems, reports and market practice and to assist those who may be unfamiliar with VaR.

What are the working groups?

We have established two working groups to discuss different aspects of VaR, covering operational considerations, methodology validation and implementation design.

The VaR Working Group meets regularly to discuss progress and to shape the implementation of our new VaR methodology.

The VaR Methodology Working Group provides an opportunity for members to understand the quantitative basis of the methodology, the reasons for the specific design characteristics, the performance and results.

Both groups are made up of representatives of our members and ISVs, whose input is an essential factor in ensuring LME VaR methodology and its implementation are successful. If you are interested in contributing to the working groups, please email us at rm@lme.com.

How will you decide what specific VaR methodology will be used?

We are currently undergoing independent validation of the model selected by the LME for its markets. The key result of the independent validation will be shared with members and the VaR Methodology Working Group. The methodology used will of course be subject to further internal governance, refinements and ultimately the final regulatory approval.

If I'm an LME member, what information will our clients need?

The LME will provide regular updates on progress towards the introduction of VaR, with introductory, technical and methodology documentation, timelines and implementation plans widely published and communicated. The introduction of VaR is of course subject to regulatory approval. As usual, we expect members to ensure that their clients are aware of the forthcoming changes to margin calculations, but we are of course happy to assist with any questions that you or your clients have.

We will also agree a communication plan with members to ensure clients are kept informed and to provide the necessary tools to ensure engaged clients clearly understand the impact of the change to VaR. 

How often will margin parameters be updated under VaR?

VaR parameters and scenarios files will be updated daily at the same frequency as SPAN parameters files. Any monthly updates to SPAN model parameters such as scanning ranges, however, will not be required, as they are not a VaR requirement.

Does VaR remove the scope of additional discretionary margin applied to members?

No, although the discretionary margin will be used for a reduced set of risk types.

What system changes is this likely to mean for my firm?

When the LME’s VaR methodology has reached a more advanced stage, we will be able to determine the system implications for our members and ISVs, and any downstream system changes required for clients.   We will provide regular updates throughout the process.

What support will you be providing throughout the process?

We will undertake a programme of engagement with all our members, ISVs and clients via meetings, dedicated forums, working groups with regular ongoing updates on our website and newsletters. Our relationship management team will be on hand throughout the transition from SPAN to VaR margining, while the relevant technical documentation and specs will be provided as soon as possible to facilitate scoping and testing to ensure a smooth transition.

When is system testing likely to begin?

We are currently in the process of confirming our preferred methodology in close discussion with our VaR Working Group, VaR Methodology Working Group (both made up of LME member firms) and ISVs. As  part of our plan for testing the new system - which is due to be implemented in late 2019/early 2020 - we are exploring the provision of a VaR calculation tool which will allow ISVs, members and their clients to input an example portfolio to simulate how our VaR methodology will calculate margin. We will provide an update as soon as this tool is available.

We will be providing a parallel test environment for an extended period which will allow you to compare the new VaR methodology and SPAN, and will give further details on the timings for this in due course.

What approval process has the model undergone?

Due to the significance of the change and the regulatory timeline we have been focusing  on the validation of the preferred methodology for the past few months, as part of our work towards gaining regulatory approval.  We have engaged with both the Bank of England and ESMA to begin the approval process, and initiated the legal and compliance steps towards submitting our application.

* SPAN is a registered trademark of Chicago Mercantile Exchange Inc., used herein under license. Chicago Mercantile Exchange Inc. assumes no liability in connection with the use of SPAN by any person or entity.