Standards bodies, industry associations and regulators are calling for greater transparency around margin models to boost the resiliency of the global derivatives markets during periods of market volatility. In a recent DerivSource ‘Living the Trade Lifecycle’ podcast, Cumulus9 managing director Rafik Mrabet discusses what this means for market participants and the tools that will help them reach this goal.
Q: In response to recent market stress events, BCBS-CPMI-IOSCO published three consultative reports: Review of Margining Practices (September 2022), Margin Dynamics in Centrally Cleared Commodities Markets in 2022 (May 2023) and Transparency and Responsiveness of Initial Margin in Centrally Cleared Markets – Review and Policy Proposals (January 2024). What are the key takeaways from these reports?
A: The first two reports were part of a phased approach of analysing the Covid-19 and Ukraine war-induced market volatility, and diving into how well CCPs are providing margin transparency to market participants. The third paper aggregates the findings into policy recommendations, which cover three main areas.
The first set of recommendations is around margin simulation tools. The recommendations ask CCPs and intermediaries such as clearing brokers to make use of existing margin simulation tools as well as create new ones for forward-looking analysis.
The second is around margin model documentation and public disclosures from the CCPs to help market participants better understand each CCP’s margining models as well as their reactiveness to procyclical (stress) events.
The third set of recommendations is around transparency provided by clearing members to CCPs and end-user clients, which tend to be commodity energy trading firms or proprietary trading firms as well as corporations that need to hedge their activities.
Q: What does transparency look like for these different market participants?
A: For CCPs, providing transparency to clearing members means better documentation of how their margining models work. This will allow clearing members to not view the margin requirements as a black box, and to be better equipped to anticipate margin calls. For CCPs, transparency is about providing the necessary breakdown of margin requirements and the necessary tools to allow clearing members to understand the reactiveness of the CCP margin models.
For clearing members on the other hand, transparency means being able to pass through those margin calls and to provide a similar level of documentation for end clients. Clearing members may use the CCP margin requirements plus certain add-ons, or the more sophisticated firms may use their own internal proprietary models, which then must be compared with the CCP margin requirements. These firms have the responsibility to provide transparency and documentation to their clients with regards to their own or the CCP margin model.
The client is taking outright or directional risk, whereas clearing members have the aggregate risk of their clients, which may be well diversified and hedged. From the client’s perspective, understanding the margin requirements is critical to reduce the likelihood of being caught off guard in a potential market stress situation.
Clearing members also have certain obligations to provide transparency to the CCP.
Q: How do CCPs need to up their game in terms of improving margin transparency?
A: In developing their margin models, CCPs are moving away from using the Standard Portfolio Analysis of Risk (SPAN) methodology, which was developed by the CME in 1988, towards a Value-at-Risk (VaR-based) methodology. With that, they have been including margin add-ons, which account for concentration charge of positions as well as liquidity charge components. As CCPs move away from SPAN, and at the same time are developing new margin components, there is a clear need to provide more transparency.
“As CCPs move away from SPAN, and at the same time are developing new margin components, there is a clear need to provide more transparency.”
VaR-based models tend to be more dynamic than SPAN and parameters or volatilities are recalibrated daily. With SPAN, the frequency of calibration may have increased during times of stress, but in general, SPAN is calibrated less often. Because market participants are used to the way SPAN behaves, transparency with newer VaR models is very important.
SPAN calibrates the margin at the product level, for example, the brent crude contracts that are traded and cleared at ICE Clear Europe. When there are offsets being provided at different expiries, they provide inter-month offsets. When there are offsets between different products, for example, within the energy sector, they would provide inter-commodity credits. Market participants are used to looking at margin at the individual contract level as well as trading strategies e.g. long one expiry and short another one.
When it comes to VaR-based margin models, everything is put in one basket. The clearing house calculates the portfolio profit and loss distribution. It does not look at it in terms of strategies and whether you have an outright here and maybe a spread strategy or butterfly strategy there. They put everything into one basket and calculate the portfolio profits and losses. For this reason, there is an even greater need for transparency providing the breakdown of the portfolio’s profit and loss distribution and having the right tools to provide that is key.
In addition, because VaR tends to provide better efficiency of margin, CCPs have had to develop margin add-ons for liquidity and concentration, and they each have their own methodologies and parameters. As you can imagine, there is a need to provide an understanding in terms of documentation of what causes these margin add-ons to change during periods of stress.
Q: What tools and solutions can CCPs and other industry players use to improve their margin transparency?
A: Generally speaking, every CCP has developed its own margin simulation tool, which it provides largely to clearing members. This makes sense because the CCP risk is against the clearing members rather than the end clients. At the same time, independent software vendors (ISVs), like Cumulus9, have replicated the CCP margining models and provide them as an alternative independent solution for market participants to use to simulate and calculate their margin. This is not just for clearing members—they are tools for the end clients as well. The industry recommendations are pushing for CCPs to provide these tools to everyone, not just the clearing members.
One challenge that firms face when using CCP margining tools is that they must log into multiple providers. For example, they could be logging into ICE’s, CME’s, and Eurex’s tools, and each CCP has its own way of uploading portfolios and looking at results. In contrast, ISVs like Cumulus9 provide a single solution that allows them to submit a portfolio mixed of positions across multiple exchanges or markets and receive the results in a standardised way.
The recommendations are also calling for more tool functionality. Not only do CCPs and ISVs need to provide a simple “what-if” analysis tool, whereby clearing members or their clients submit portfolios and get the output or results in terms of the margin. They also need to provide added functionality enabling market participants to prepare for changes in the margin requirements. Especially in the context of VaR-based models, which are changing every day, firms need to know how these margin models would react in the case of another stress event.
“The ability to forecast margin changes as the world enters new volatile or stressed market conditions is very important.“
The ability to forecast margin changes as the world enters new volatile or stressed market conditions is very important. The recommendations say that to be better prepared for another stressed market event and increased margin calls, firms need margin simulation tools that enable firms to forecast what would happen to margin requirements if volatility should, for example, double over the next few days. These capabilities are not easy to implement or develop because it requires unpacking the margining system to be able to run them in a forward-looking way.
At the same time, firms also need the ability to look backwards and see how margin requirements looked in the past and how they responded to previous stressed market conditions. Some call it crisis replay. That also helps with understanding the reactiveness of the model and enables market participants to better manage their liquidity. The better they know how the margin model will react, the better prepared they will be in terms of managing their exposure. This also enables the internal risk team to work closely with the treasury and collateral management teams to prepare for the right collateral that would be posted as and when they get these margin calls.
Q: What advice would you give firms looking to improve their margin transparency in line with industry recommendations?
A: Market participants should engage closely with their clearing members and the CCPs to understand their margin methodology and use the simulation tools available to get a better understanding of how they work. Trading firms that are used to the SPAN methodology need to adapt their processes and train their teams in how VaR-based models behave. That is the only way for them to be equipped to face increasing margin calls during inevitable future stress periods.
*To hear more on this topic, please listen to the podcast here.
