Industry research brings whole ethos behind margin calls into debate

The World Federation of Exchanges (“WFE”), the global industry group for CCPs and exchanges today published a Research Working Paper on the Procyclicality of CCP Margin Models.

The WFE Research report finds that there are tensions and trade-offs between the need for risk sensitivity and the potential procyclicality of CCP Margin Models—that is, the need to call for margin when market conditions deteriorate. Accordingly, questions about procyclicality would be better addressed by acknowledging that procyclicality is a property of the system as a whole and so requires system-wide solutions, identifying interdependencies, incentives, and behaviours across the ecosystem that could lead to unsafe situations.

Margin requirements are a fundamental part of CCPs’ management of counterparty risk, ensuring that the exposure to a failing member will be sufficiently collateralized and, as consequence, the CCP creates a buffer against financial contagion. The Paper concludes that calls to address the procyclicality of margin calls by further recalibrating margin models are misplaced, because:

• Margin calls are largely driven by variation margin, not initial margin – in other words, margin calls are about market participants properly covering losses on their positions.
• Mitigating procyclicality through margin model calibration is limited by the fact that models need to be risk sensitive to ensure that the CCP remains adequately collateralized at all times, and by the need to keep central clearing economically efficient.
• The stochastic nature of the processes involved implies that the same parametrization, under different initial conditions, may lead to different outcomes.  Instead of trying to predict all possible states of the world (and markets) it is necessary to recognise that these can change and that it is important to have the flexibility to react to the facts on the ground. As post-Lehmans regulations recognised, this should be carried out by a neutral third party, rather than being left in the hands of private participants with risk positions
• Constraining the ability of the CCP to set prudent but adequate margins has the double negative effect of incentivising risk-taking while curtailing the ability of the CCP to correctly collateralize its exposures.

To illustrate these limitations and trade-offs, WFE Research empirically examined how some standard market risk models react to the S&P 500 volatility increase observed during March 2020 and quantified the trade-offs involved.

The analysis shows why the less procyclical models  tend to be less able to capture the sharp increase in risk and would have led to much larger losses had the hypothetical member defaulted. On the other hand, while adding margin floors and other standard anti-procyclicality measures contribute to reduce procyclicality, given the magnitude of the shock, they cannot prevent the sharp increases in margin observed in March without conflicting with the need of protecting the CCP- and therefore the system as a whole – while keeping central clearing economically viable.

Nandini Sukumar, Chief Executive Officer of the WFE, said: “Procyclicality is a function of the ecosystem and needs to be examined holistically. CCPs exist to manage and mitigate risk and they understand their responsibility to the system. We call on other stakeholders to do the same.’’

Pedro Gurrola-Perez, Head of Research at the WFE and the author of the paper said: “To progress in the question about procyclical effects in the system, we should step away from reductive approaches and acknowledge the intrinsic limitations to what margin models can do to mitigate procyclicality. The fact that fragilities in the system persist despite the anti-procyclical measures already in place, as we saw in the dash-for-cash in March, is a wake-up call to the need of a systemic perspective.”

Click here to read the full report.