FICC uses a Value-at-Risk (“VaR”)-based methodology for calculating its Clearing Fund. VaR provides an estimate of the possible losses for a given portfolio based on a given confidence level over a particular time horizon. It is intended to cover the uncertainty of market volatility for any given portfolio. In general, FICC assumes a 3-day liquidation period with a 99% confidence interval, though some member types are margined at a higher confidence level.
The three key attributes of VaR are: (1) market volatility; (2) a time horizon; and (3) a confidence level. Market volatility drives gains and losses for a given portfolio. Time horizon describes the period of time, usually defined in terms of the number of days, required to close out a portfolio. Finally, the confidence level determines how much protection FICC requires. For example, if a 99% three-day VaR is $10 million, it means that the maximum expected loss over a three-day period is equal to or below $10 million, 99% of the time.
The objective of the MBSD VaR model is to establish Clearing Fund with sufficient resources to withstand, at a minimum, a default by a member to which FICC has the largest exposure in extreme but plausible market conditions. The VaR Calculation of an individual portfolio will never be below a defined percentage of the member’s gross portfolio positions (currently set to 5 basis points). To measure portfolio risk effectively, the model quantifies market volatility while taking into account the effect of a portfolio diversification and hedging.