April was a busy month for IM and VM headlines. Lynn Strongin Dodds looks at the latest developments and research that are to change the industry.
The subject of margin has been in the news lately. The International Securities and Derivatives Association (ISDA) published its annual margin survey while the FIA called upon international regulators to continue their work on margin transparency.
Meanwhile, the World Federation of Exchanges (WFE) introduced a new method for measuring margin model responsiveness to navigate changing market conditions.
Well-worn territory
In many ways, ISDA and FIA were going over well-worn territory. The derivatives association’s yearly tome, albeit anticipated, provides a snapshot of initial and variation margin activity. This year, it revealed that $1.4 trillion broken down into $462.0 billion of IM and $944.5 billion of VM collected last year by 32 firms was unchanged from 2022’s tally of $325.7 billion of IM and $1.1 trillion of VM.
The 32 organisations included 20 subjected to the first phase of regulatory IM requirements for non-cleared derivatives in September 2016 (phase-one entities), five of the six phase-two firms and seven of the eight phase-three entities. Total margin received by these phase-oners was $1.3 trillion, down 0.6% from the previous year. Broken down, this comprised a 40.8% hike to $432.3 billion of IM from 2022 but a 13.5% drop to $851.0 billion of VM.
As for the FIA, its clarion cry was in a letter submitted in response to a consultation on IM requirements in centrally cleared derivatives markets in January by the Basel Committee on Banking Supervision (BCBS), the Bank for International Settlements’ Committee on Payments and Market Infrastructures (CPMI) and the Internation).al Organization of Securities Commissions (IOSCO) (https://www.bis.org/bcbs/publ/d537.html).
The standard setters were asking for comment on 10 policy proposals that aim to improve participants’ understanding of IM calculations and potential future margin requirements. The FIA believed that that the proposed requirements for increased transparency into the process used by central counterparties (CCPs) to set IM requirements would give clearing members and their clients more ability to prepare for margin calls, thereby reducing liquidity risk in financial markets.
The need for greater clarity has been evident in recent periods of stress such as the pandemic and geopolitical tensions when IM requirements accelerated quickly as markets became volatile, resulting in calls for additional margin. This in turn put pressure on the ability of clearing members and market participants to fund these demands.
Responsiveness of margin models
The WFE paper is along the same lines but differs from the other two, in that it digs deeper into the nitty gritty and proposes a standardised measure of margin responsiveness across the international clearing community. The exchange and central clearing organisation said that the research which was conducted by Dr. David Murphy, Visiting Professor at the Department of Law of the London School of Economics, offers a “novel measure of IM model reactiveness or procyclicality that, unlike other measures, does not rely on particular risk factor paths and quantifies the uncertainty in the measurements.”
It noted that the responsiveness of IM models, both for centrally and non-centrally cleared trades, has been part of the discussions about how to best manage liquidity pressures in the financial system. However, the debate about how reactive margin should be to changes in market conditions has been hampered by the lack of a generally accepted and statistically sound way of measuring such responses.
Margin procyclicality
The researchers said that common measures of model procyclicality, including the method being proposed by the Joint Working Group on Margin (JWGM) established by BCBS are strongly dependent on the individual scenarios and, therefore, cannot be used to compare margin models across different market conditions. They are also unlikely to provide a sufficient understanding of how models as well as anti-procyclicality tools can behave when there is an unanticipated change in the direction of markets. Also, they ignore the uncertainty surrounding the measurements. ( WFE’s Richard Metcalfe is speaking on an upcoming DerivSource webinar on Margin Procyclicality. )
The researchers said that the methodology proposed in their paper overcomes these limitations by utilising an impulse response function (IRF) in a Monte Carlo simulation setting and capturing the variability or uncertainty surrounding margin model reactiveness. In addition, they noted their tool to assess and compare models does not depend on a particular scenario.
The researchers also noted that the analysis sheds light on different aspects of procyclicality management such as a trade-off between model reactiveness and the uncertainty of future model behaviour. Additionally, they found that the use of a stress period and the addition of a buffer – two commonly used anti-procyclicality (APC) tools – do not significantly reduce the likelihood of a model over- or under-reacting. In particular, the buffer performs poorly.
In the end, they called for the adoption of an outcome-based approach to procyclicality, recognising that there is no single correct level of procyclicality. “There are only acceptable choices given a specific situation such as risk factor dynamics, portfolio characteristics, participants’ funding liquidity arrangements, and the desired trade-off between reactiveness, potential extent of over-reaction, and margin accuracy,” they added.
This research also highlights the need for an adaptation of the current methodology proposed by BCBS-CPMI-IOSCO before it is put into effect: either by capturing the degree of uncertainty in the measurement, or by including an appropriate warning of the standard setter’s proposed method’s limitations.
Learn more via upcoming webinars:
Margin Procyclicality – Curbing Future Risks (May 15th)
EMIR 3.0 – What’s Next? (May 7th)
