Encumbrance – along with collateral-shortage — is one of our favourite post-financial crisis terms.
A new paper from the Bank for International Settlement’s latest Quarterly Review deals with both in relation to central clearing, scheduled to cover all OTC derivatives by the end of next year.
As a reminder, the biggest tool in a Central Counterparty’s (CCP) risk management portfolio are margin calls — be they initial or changeable to accompany volatile price moves. Initial margins tend to cover something like 99 per cent of hypothetical losses over a five-day period, with the CCP collecting high-quality liquid assets like government debt to cover any losses. Variation margins, meanwhile, increase or decrease to coincide with sharp changes in the value of dealers’ portfolios.
Margin calls have also become a hot-button topic in the clearing debate, with some commentators accusing CCP margin calls of exacerbating market volatility, with dealers having to scramble to come up with additional collateral right when markets arguably need stability. So-called pro-cyclicality.
It’s a point not lost on the BIS’s Daniel Heller and Nicholas Vause:
First, CCPs could benefit from raising and lowering initial margin requirements as levels of market volatility change, or, in order to dampen undesirable procyclical effects, setting stable initial margins according the highest level of market volatility. The left-hand panels of Graph 2 show that appropriate initial margins can vary significantly with prevailing levels of volatility, and Graph 3 shows that prevailing levels of volatility can change markedly over time periods as short as a few weeks, especially for CDS. As discussed above, G14 dealers appear to have enough unencumbered assets to meet initial margin requirements commensurate with even the highest levels of market volatility, while non-margin resources could be put at greater risk by not varying initial margins. This is illustrated in Graph 4, which shows in the lefthand panel how daily changes in the market value of an index of North American CDS (in blue) compare with a fixed initial margin requirement intended to cover 95% of losses over time (in purple) and a variable initial margin requirement intended to cover 95% of possible losses at each moment in time (in red). The variable margin requirement tends to rise ahead of the largest losses. This reduces the size of the largest shortfalls compared with those associated with the fixed margin requirement, as shown in the right-hand panel. Furthermore, it avoids clustering of margin shortfalls. Losses exceed the fixed initial margin on 16% of trading days between mid-2008 and mid-2009, which is significantly higher than the intended 5%.
Note that while CCPs can benefit from varying initial margin requirements with changes in market volatility, such a policy could also lead to undesirable procyclical repercussions. It could, for example, boost the cost of borrowing assets that CCPs would accept as collateral and encumber more of dealers’ other assets in the process whenever market volatility increased. This could lead dealers to unwind other positions, potentially exacerbating the increase in volatility and, hence, margin requirements. Such feedbacks could be avoided, while protecting CCPs to at least the same degree, by fixing initial margins at levels commensurate with high volatility. For much of the time, however, this would of course encumber more collateral at the CCP than under a timevarying regime.
Super-high, super-safe initial margins. The trade-off is that more of dealers collateral will be tied up at CCPs at a time when good-quality collateral seems to be becoming scarcer and scarcer.
On that point the BIS authors reckon “dealers already have sufficient unencumbered assets to meet initial margin requirements, but that a few may need to increase their cash holdings to meet variation margin calls in a timely way.” No word if they have enough to meet ‘high volatility’ initial margins.
Related links:
A glimpse at failed central counterparties – FT Alphaville
Which came first – the margin call or the commods mayhem? - FT Alphaville