Central counterparty anti-procyclicality tools: a closer assessment

Atsushi Maruyama; Fernando Cerezetti

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Reflecting upon the lessons learnt from the 2007-8 crisis, regulators traced the unintended consequences of procyclicality in the securities financing and bilateral OTC derivative markets to basically two components: the excessive leverage during the economic expansion; and liquidity pressures in the downturn. The responses came in the form of regulatory guidance around stable-through-cycle metrics for initial margin and collateral haircuts.
There are, however, a number of variables that influence volumes and open interest of contracts in CCPs, and isolating initial margin and collateral haircut effects may be challenging. Moreover, while CCPs are not risk takers but risk managers, they may have limited control on how margins and haircuts are promoted downstream to clients by the clearing members.
Similarly, whilst the changes to initial margin requirements and collateral haircuts can cause funding pressures on their own, it is the variation margin that typically reacts first and, most importantly, accounts for the largest portion of the calls issued by CCPs. A dominant role of variation margin in stress market comes from the fact that one-day price variation weighs only marginally to the initial margin calculation.
The authors argue that the best mitigation mechanisms for procyclicality are achieved through the establishment of an outcome-based approach and enhanced disclosure of CCP margining practices. A desirable outcome is predictability, especially in regards to intraday mark-to-market of contracts. For instance, frequent and smaller intraday variation margin calls can create strong incentives for reduction of positions before losses accumulate to the point of default.

Abstract

In the new market and regulatory environment following the 2007–8 crisis, central counterparties (CCPs) need to find the right balance between ensuring the safety of their business and avoiding the creation of additional distress in the market in the form of procyclical margin calls. However, balancing these conflicting goals poses a number of challenges, and no one-size-fits-all solution appears to exist. This paper investigates whether the substantial focus placed on the procyclicality of initial margin reflects both the original concerns at the time of the crisis and the intrinsic modus operandi of CCPs. We argue that the imposition of a procyclicality framework shaped by lessons learned from securities financing and bilateral over-the-counter markets to CCPs may have created unexpected challenges. We support the idea that the best mitigation mechanisms for procyclicality may be achieved through the establishment of an outcome-based approach and the enhanced disclosure of margining practices, especially regarding intraday mark-to-market procedures and variation margin calls.

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