Lynn Strongin Dodds looks at the ongoing debate about margin procyclicality at CCPs and the renewed actions of regulators
It is far from surprising that the recent spate of volatility has refocused regulators minds on the fissures in the financial system. Spikes in prices translate into higher margin calls and concerns over procyclicality are back on agenda for the central counterparties (CCPs).
These issues are far from new. They first came onto the scene in the wake of the global financial crisis and the regulatory push for as many assets as possible to go through central clearing. The market risk models used to estimate initial margin (IM), whether for centrally or bilaterally cleared trades, are programmed to be sensitive to changes which means when risk escalates, IM requirements tend to rise in tandem.
Past views
The Bank for International Settlements first published a report in 2010 recommending several measures to reduce the procyclicality arising from margin practices. Seven years later, the Committee on Payments and Markets Infrastructures (CPMI) and the International Organisation of Securities Commissions (IOSCO) produced the final version of Principles for Financial Market Infrastructures, advising CCPs to set “relatively stable and conservative margin requirements that are specifically designed to limit the need for destabilising, procyclical changes.”
However, these edicts were developed during a time of benign interest rates and market stability. A confluence of a pandemic, geopolitical risks and changing monetary policy over the past three years has served as a wake-up margin call. According to the latest report from the International Swaps and Derivatives Association (ISDA), 2022 alone saw IM and variation margin (VM), collected by the 20 phase-one firms, which represent the largest derivatives dealers, jump 5.6% to $1.3 trillion over 2021. That encompassed $307.2 billion of IM and $983.7 billion of VM – a respective 7.4% and 5% hike over 2021.
The survey also revealed that the amount of IM posted for cleared interest rate derivatives (IRD) and single-name and index credit default swaps (CDS) climbed 18.8% to $384.4 billion. This was split into $314.3 billion for IRD transactions and $70.1 billion for CDS exposures.
The debate resurfaces
This upsurge reignited the debate over margin models and the industry stalwart – the standardised portfolio analysis of risk model better known as SPAN. It suffered because the parameters needed for margin calculations are calibrated manually which meant that clearinghouses had difficulty in adjusting margins quickly enough to keep up with gyrating prices.
This was not the case with the value at risk (VaR) models which is why Eurex won plaudits for Prisma, its self-calibrating VaR product which was launched nearly ten years ago. It proved its mettle in 2020 by ingesting new data as the Covid 19 crisis began in March and automatically updating margin levels on a daily basis. The performance helps explain why other CCPs, such as ICE, are moving to VaR based models in a staged process for their different product range.
“Margin procyclicality was a big issue years ago in the fixed income world but then margins barely moved during the zero-interest rate environment. However, over the past three years we had Covid 19, the invasion of Ukraine, higher interest and inflation rates and this scared the market.” – Jo Burnham, OpenGamma
“Margin procyclicality was a big issue years ago in the fixed income world but then margins barely moved during the zero-interest rate environment,” according to Jo Burnham, risk and margining SME at derivatives analytics firm OpenGamma. “However, over the past three years we had Covid 19, the invasion of Ukraine, higher interest and inflation rates and this scared the market,” she adds. “Every time we have one of these events, it makes everyone look at the rules and ask do we need more dress rehearsals.”
Burnham believes their needs be greater awareness of the margin models and processes that are being used. “Initial margin is supposed to increase when there is volatility, but I think there is some confusion regarding IM,” she says. “There is a better understanding of VM.”
Spotlight on greater transparency and broader issues
Joshua Hurley, director of Sionic agrees, adding that in general CCPs do not always fully explain how margin models work especially in times of stress. “There should be additional information and layers of greater granularity in terms of how these models react or change in market conditions. Clients want to be able to better understand the impact of volatility but at the moment there is a knowledge gap between users and providers that needs to be closed.”
Hurley is not alone in his views but as Dmitrij Senko, a member of the executive board and chief risk officer at Eurex Clearing, points out “We have always been transparent but sometimes it is difficult to predict the trajectory of margins because it depends on how the market will react.“
“We are happy to contribute to the discussions regarding anti cyclicality tools, but we do not believe the topic should only be focused on CCPs. We also think there should be a focus on clearing members and the practices that they might need to improve in the bi-lateral space.” – Dmitrij Senko, Eurex Clearing
He adds, “We are happy to contribute to the discussions regarding anti cyclicality tools, but we do not believe the topic should only be focused on CCPs. We also think there should be a focus on clearing members and the practices that they might need to improve in the bi-lateral space.”
Richard Metcalfe, head of regulatory affairs at the World Federation of Exchanges also believes that there are broader problems. “CCPs are very good at multi-lateral netting, reducing risk and collateral management,” he says. “They take an informed view of what appropriate tweaks are needed. However, they have had to deal with expanding and contracting liquidity and getting an overview of that across the whole system is not that easy. It is a technical issue but there has always been an element of judgement when measuring it.”
More can be done, adds Daniel Geddes, head of product management at Torstone Technology. “When it comes to handling procyclicality, we see a range of approaches adopted by CCPs to the Principles for Financial Market Infrastructures (PFMI) guidelines, some being much more proactive and others paying lip-service to the guidance. In our view, there is clearly more that can be done by the industry to address this issue.” he says.
Jurisdictional differences
Jurisdictions differ in how they tackle these obstacles despite the emphasis on harmonisation. In general, the US is inclined to adopt principle-based regulation, while the Europeans typically prefer more prescriptive guidance. However, the views expressed by Fabio Panetta, Member of the Executive Board of the European Central Bank were echoed by many.
Speaking at the Fifth Joint Deutsche Bundesbank, European Central Bank and Federal Reserve Bank of Chicago Conference on CCP Risk Management, he stressed that mitigation of margin procyclicality is reflected in both the global standards and the EU rules for CCPs. However, he said that recent periods of extreme market volatility have highlighted the need to do more.
“The review conducted in 2020 by the Basel Committee on Banking Supervision, CPMI and IOSCO on margin practices provides us with a clear roadmap for action,” he said. “This includes enhancing CCPs’ tools to anticipate stress and reflecting margin procyclicality in the development of countercyclical measures and the validation of margin models. Margin transparency should also be enhanced, in terms of both the transparency of CCPs vis-à-vis clearing members and the transparency of clearing members vis-à-vis clients.”
At the moment, the consultation process is in full swing in Europe with the European Securities and Markets Authority (ESMA) releasing its final review in July.
The European watchdog suggested amendments to regulatory technical standards (RTS) to drive further harmonisation of CCP frameworks for identifying and mitigating procyclicality in their margin policies. The aim is to reinforce the ability of CCPs to contain the impact of large margin changes on clearing participants and their clients. They are also designed to prevent pockets of liquidity stress creating contagion in other parts of the financial ecosystem.
One of the key recommendations is for CCPs to consider a larger cushion under certain circumstances. To date, CCPs are required to apply a margin buffer at least equal to 25% of the calculated margins, which is to be temporarily exhausted during periods when calculated margin requirements are rising significantly.
ESMA has submitted its final report to the European Commission for consideration within three months. If adopted, the amended RTS will then be subject to ratification by the European Parliament and Council.
Related Reading:
ISDA Margin Survey Shows $1.4 Trillion in Margin Collected at Year-end 2022 – Derivsource
Derivatives Clearing in Europe: Wrinkles Still Need Ironing Out – Derivsource
2022 Outlook: Brexit and the Impact on Derivatives Mid-year Update – Derivsource
