**” The Federal Reserve’s latest research challenges the adequacy of current cryptocurrency risk models in uncleared derivatives markets, proposing that crypto assets warrant their own dedicated risk class within the ISDA Standardized Initial Margin Model (SIMM). By splitting crypto into ‘pegged’ (stablecoins) and ‘floating’ (unpegged assets like Bitcoin and Ethereum) buckets, and calibrating bespoke risk weights using crypto-specific stress periods and proxy indexes, the paper aims to prevent significant underestimation of potential losses—potentially by 40-60% in stressed scenarios—while enhancing overall market resilience. “**
Fed Paper Challenges Cryptocurrency Risk Models, Calling for Initial-Margin Weights for Crypto Derivatives
The push stems from the explosive growth of cryptocurrency markets, which now boast a total capitalization exceeding $4 trillion. This surge has spilled into traditional finance through uncleared derivatives—swaps, forwards, and other bilateral contracts not processed through central clearinghouses. These instruments allow institutional players to gain exposure to crypto price movements without direct ownership, but they introduce counterparty risk that margin requirements are designed to mitigate.
Initial margin serves as upfront collateral posted by both parties to cover potential future exposure over a 10-day close-out period, targeting the 99th percentile of losses. The industry relies heavily on the ISDA SIMM, a sensitivities-based model that aggregates risks across predefined classes like interest rates, foreign exchange, equities, commodities, and credit. SIMM has proven effective for traditional assets, with total collected initial margin stabilizing around $431 billion in recent years.
However, cryptocurrencies do not fit neatly into these buckets. Their price dynamics—driven by factors like network sentiment, regulatory announcements, technological developments, and 24/7 trading—differ markedly from commodities or FX. Assigning crypto risks to existing categories risks distorting margin calculations, often leading to under-collateralization during stress events.
The paper highlights that SIMM’s current structure, conceived when crypto market cap was under $1 billion, lacks provisions for digital assets despite their mainstream integration. Researchers examined how crypto-sensitive trades would be treated today and concluded that lumping them into commodities or FX underestimates tail risks. Crypto exhibits sharper drawdowns, lower correlations with traditional markets during normal periods, and sudden regime shifts in volatility.
To address this, the authors recommend establishing a new “crypto” risk class within SIMM, further divided into two buckets:
Floating cryptocurrencies : Unpegged assets such as Bitcoin (BTC), Ethereum (ETH), Binance Coin (BNB), Cardano (ADA), Dogecoin (DOGE), XRP, and similar tokens that experience high, independent volatility.
Pegged cryptocurrencies : Stablecoins designed to maintain a fixed value, typically to the U.S. dollar, with lower but still distinct risk profiles due to potential de-pegging pressures.
This bifurcation acknowledges fundamental differences: floating assets can swing dramatically based on speculative flows, while pegged ones face risks tied to reserve adequacy, redemption runs, or algorithmic failures.
Calibration of risk weights for the new class would follow SIMM’s established methodology but incorporate crypto-specific inputs. Risk weights derive from historical data, including a designated stress period and recent observations. For crypto, the paper suggests using an equally weighted proxy index combining floating and pegged assets to simulate market-wide behavior. This benchmark would capture idiosyncratic volatility better than traditional proxies.
Stress calibration would draw from crypto’s own history—periods like the 2022 market crash, Terra/Luna collapse, or rapid rallies—rather than forcing alignment with equity or commodity crises. The approach aims to ensure margins reflect the 99th percentile potential loss accurately, reducing the likelihood that posted collateral falls short in extreme scenarios.
In uncleared markets, inadequate margins amplify systemic vulnerabilities. If a counterparty defaults amid a crypto flash crash, insufficient initial margin could force fire sales, contagion, or broader liquidity strains. The proposal seeks to align collateral practices with actual exposures, promoting safer participation by banks, hedge funds, and other entities active in crypto-linked derivatives.
The paper also notes liquidity considerations. Many crypto derivatives trade on decentralized platforms or offshore venues with thinner order books than traditional markets, potentially extending close-out times beyond the standard 10 days. Higher or adjusted margins could account for this, though the primary focus remains on volatility and correlation modeling.
Broader implications extend to regulatory alignment. U.S. rules under the Uncleared Margin Rule (UMR) adopt BCBS-IOSCO standards, which SIMM supports. Incorporating a crypto class would require ISDA updates—likely through semi-annual recalibrations—and coordination among global regulators. While not a formal policy proposal, the staff analysis signals growing supervisory scrutiny as crypto derivatives volumes rise.
Market participants already grapple with fragmented margin practices for crypto exposures, often relying on bespoke models or higher discretionary buffers. A standardized crypto class could streamline negotiations, reduce disputes, and foster deeper liquidity in regulated venues.
The research underscores that as digital assets mature, legacy frameworks must evolve. Treating crypto as “just another commodity” overlooks its unique drivers and risks. By advocating tailored initial-margin weights, the Fed paper lays groundwork for more robust risk management in an increasingly hybridized financial landscape.
Disclaimer: This article is for informational purposes only and does not constitute financial, investment, or legal advice. Market conditions can change rapidly.