Market volatility and consequent spikes in margin calls over the last four years have renewed industry and regulator focus on margin procyclicality within CCPs.
In a recent DerivSource webinar, Richard Metcalfe, head of Regulatory Affairs, World Federation of Exchanges (WFE), and Joshua Hurley, director, Banks and Markets, Davies discussed current recommendations for improving central counterparty (CCP) margin procyclicality management and explored how key stakeholders can improve anti-procyclicality procedures and tools to mitigate future risk.
Q: What is margin pro-cyclicality?
Hurley: Procyclicality is the nature of financial variables to move around the economic cycle. There are various tools to combat this. For example, in bank capital management, firms build up a countercyclical buffer during good times so that when credit is needed in bad times, there is more loss absorption and credit shouldn’t dry up.
In terms of margin procyclicality, it is the nature of margins to increase at the time when there is the increased stress in the markets.
Margin procyclicality has been a big topic for the last four years as derivatives trading firms faced significant margin calls during episodes of high volatility, for example with the onset of the Covid-19 pandemic in 2020 and with Russia’s conflict with Ukraine starting in 2022.
The primary focus of the debate around procyclicality is on initial margin (IM) and most of the discussion centres around CCPs and the way margin models responded during the various crises over the last few years. Model design and reactivity is important when it comes to tackling procyclicality and overall risks and cost to the market.
Several papers have recently been published on the topic and regulators are expected to set out recommendations in new regulatory standards. The Basel Committee on Banking Supervision, the Committee on Payments and Market Infrastructures, and the International Organization of Securities Commissions (BCBS-CPMI-IOSCO) recently published a paper on margin reactivity and transparency (Transparency and responsiveness of initial margin in centrally cleared markets: review and policy proposals), for which the comments period just closed.
“Model design and reactivity is important when it comes to tackling procyclicality and overall risks and cost to the market.” – Joshua Hurley, Davies
Q: What tools are traditionally used to manage margin procyclicality?
Hurley: The foundation for managing procyclicality is the margin model. Different models have different levels of reactivity—Value-at-Risk (VaR)-based models tend to be slightly more reactive than parametric models, for example. Firms can also make different choices within their model design. If a model has a strong weighting on recent observations, for example, it will likely be more reactive if there is a sudden spike in the market, particularly if it is a VaR-based model.
There are three main tools for managing procyclicality set out in the EU EMIR rules, and often used globally. The first is a 25 percent buffer on a margin requirement. If the current margin is 100, the buffer would be 125. That is quite a blunt measure for anti-procyclicality.
The second tool is to use longer look-back periods. This ensures that current market volatility does not completely dominate IM calculations and should act to provide a floor on the IM amounts.
The third tool is to look at stress periods, weighting current IM with the stressed IM to produce a blended IM, which also gives more of a floor during benign market conditions.
Other anti-procyclicality tools include overriding a model to accommodate known market changes or events—something which many firms now prefer.
Q: What are the challenges in measuring procyclicality?
Metcalfe: A recent paper published by Argyris Kahros and Marco Weissler of the European Central Bank (ECB) noted that all approaches to anti-procyclicality can vary in their effectiveness, and each can give rise to a range of outcomes depending on exactly how markets go from one volatility regime to another. The authors said that the performance of anti-procyclicality (APC) measures is “empirically ambiguous”.
Another paper produced by WFE’s Pedro Gurrola-Pérez and Dr David Murphy (London School of Economics) entitled The Impulsive Approach to Procyclicality, noted peculiar effects with models and APC tools. . The paper noted that, with some models, it is possible to have a combination of high margin until an event, followed by a dip in margin requirement when a buffer is released and then overshoot. This observation is echoed in the ‘Holistic review published by the Financial Stability Board(FSB) in November 2020.
Experience shows that if you release a buffer all at once, there is a possibility that some models might overshoot. Some observers wonder if it is better to fade a buffer out rather than release it all at once.
Hurley: There are a lot of questions around buffers. If there is a low margin, the 25 percent buffer will get eaten very quickly if volatility suddenly spikes. Once in a higher margin environment, at what point does that 25 percent get added back on? What is the governance process around that?
Metcalfe: Some WFE members think that an override of the model is the best anti-procyclicality weapon. The model may tell them they should put up IM by X, but they need to make a judgment call instead taking into account market-wide conditions – ideally with more information from clearing members about their current circumstances.
“Some WFE members think that an override of the model is one of the best anti-procyclicality weapons. The model may tell them they should put up IM by X, but they need to make a judgment call instead.” – Richard Metcalfe, WFE
Metcalfe: We are operating in a territory where the future might not look like the past. That makes it hard for a CCP to say categorically that a change in volatility means its margins will change from X to Y. This is driven by how people in the markets react to changes in volatility and price. There is a worrying lack of attention among some market participants as to how volatility changes might affect IM. Some model and prepare for this but others don’t.
Q: What other issues affect how the industry manages procyclicality?
Metcalfe: Collateral liquidity has been an issue—especially among non-financial counterparties trading commodities—although that was partly because of limits around what type of collateral some participants could post. Commodities firms and pension funds are not necessarily awash with liquidity and this needs to be considered when designing a system and how much leeway a CCP should have to judge things.
Multilateral netting is also a huge factor, when the whole system is heavily collateralised, because multilateral netting is more efficient. With Libor, part of the reason it was so easy to push around was because everybody had moved to a collateralised approach. Repo is cash and that form of collateral is king. Collateral is a fact of life, and it was the lack of access to funding, even on a collateralised basis, that took down Lehman Brothers and Bear Stearns.
When it comes to collateralised systems, the CCP is benign. It is also a neutral third party with the best overview of the market, performing an impartial function. There is always room for improvement and WFE believes that disclosures from clearing members to CCP should improve.
The fact that different APC standards apply in different parts of the world is problematic. EU regulation is relatively prescriptive and, although over time we may see more discretion going to ESMA, in the US, the issue is mostly left up to the judgment of the CCP, working with their regulator. More prescriptive legislation could hinder firms’ ability to take a more judgment-based approach. At the end of the day, firms need to have a strong relationship and dialogue with their regulator.
Q: What lessons are there from previous years for how market participants can improve their preparedness?
Hurley: The biggest thing is that risk does not go away. CCPs can transform risk, for example, – they may lower counterparty risk but then you arguably end up with increased liquidity risk. Liquidity is still a critical factor for firms to continue focusing on and also subject to regulatory reviews. The debate shows firms will never know exactly how much liquidity they will need, but they need to have a backup plan to their backup plan to ensure access to funding in a crisis. This debate keeps going, because much like modelling operational risk, managing procyclicality is very hard to get right. It may be many years before we have an agreed measure.
Another important lesson is that communication across the industry is essential for solving industry-wide issues like this. The more market participants and other players engage in industry discussions on this issue, the better the outcome for everyone.
*Watch the video recording of this webinar here.
