Regulators urged to back non-cash variation margin

Market participants want regulators to support the use of non-cash instruments for variation margin (VM) calls, in response to stress events in recent years that have led to sharp spikes in margin requirements. Non-cash collateral is already accepted by dealers and some clearing houses as initial margin, but its uptake for variation margin is rarer.

Jean-Marc Buis, head of market, liquidity and derivatives risk at AXA Group, said a key driver for systemic risk was “excessive reliance on cash as collateral as opposed to non-cash collateral”. Consequently, he argued the increased acceptance of non-cash VM “requires specific attention”.

Buis was speaking at a hearing organised by the Financial Stability Board on May 31 to discuss its recent consultation on improving non-bank readiness to meet margin calls. The consultation runs until June 18.

The FSB analysed incidents of market stress, including the March 2020 turmoil at the start of Covid lockdowns, the collapse of family office Archegos Capital Management in March 2021, turbulence in commodity markets after Russia’s invasion of Ukraine in February 2022, and stress in the UK liability-driven investment (LDI) fund segment in September 2022. The FSB found that, in general, non-bank institutions were ill-prepared to withstand margin and collateral calls because of weaknesses in their own liquidity risk management and governance.

In response, the FSB recommended improved liquidity management techniques at non-banks, including stress-testing. The global regulatory body also called for the diversification of margin and collateral transformation processes.

However, participants at the May 31 outreach event suggested the FSB’s framework was missing explicit recommendations that would allow reduced reliance on cash when it came to meeting variation margin calls. The FSB recommended: “Market participants should maintain sufficient available cash to meet cash-only margin calls with a high degree of certainty in the called currency, time zone and location of delivery.” This prompted market participants to urge more discussion of using cash-like or non-cash means to meet these calls.

James Hopegood, director of asset management regulation at Alternative Investment Management Association agreed with Buis on this point, calling the FSB’s wording “too strict”.

An in-house counsel at an energy company felt the FSB’s recommendations did not offer sufficient recognition of the fact that some non-banks were restricted from holding cash reserves on the same scale as a bank.

“In some ways, this looks like applying banking standards to market participants where that is not possible or appropriate,” said the in-house counsel.

Collateral transformation pressure

Jan Mark van Mill, managing director of the multi-asset team at APG Asset Management, warned that pressuring buy-side firms to hold large amounts of cash collateral at all times could improve resilience to margin spikes, but at the cost of causing other problems.

“Too much cash increases operational and counterparty credit risk for investors,” he said.

Instead, investors need to hold a mix of cash and high-quality liquid assets such as investment-grade bonds, to keep their credit risk diversified. Therefore, as long as most counterparties and central counterparties (CCPs) require cash VM for many asset classes, “what comes to the forefront is the reliance on the repo market” for collateral transformation, according to van Mill. This allows buy-side firms to convert their holdings of bonds into cash when needed to meet margin calls.

However, Ido de Geus, head of fixed income at PGGM, stressed that buy-side firms were not operating in isolation from the wider financial ecosystem. Banks could seek to reduce the balance sheet consumption of repo in the face of tougher capital requirements, which made it more difficult for their clients to access collateral upgrade trades. De Geus said buy-side firms “shouldn’t be penalised” as a result of this. Wider acceptance of non-cash VM was an obvious alternative if repo market access was constrained.

CCP transparency

The FSB’s report covers both cleared and non-cleared markets. On the cleared side, the in-house counsel at the energy company reiterated calls from market participants for greater transparency around margin models used by CCPs. This was one of the major complaints prompted by the spike in energy prices after Russia’s invasion of Ukraine.

“We don’t have all of the necessary information for one of the greatest drivers of the ‘dash for cash’ … which was the inflexibility and unpredictability of margin requirements on exchanges and CCPs during the commodity crisis,” said the in-house counsel.

Too much cash increases operational and counterparty credit risk for investors

Jan Mark van Mill, APG Asset Management

Global regulatory bodies are already looking into this question, and enhanced margin transparency was also included in the latest version of the European Market Infrastructure Regulation. The European Securities and Markets Authority now has a mandate under Emir 3.0 to specify how CCPs should provide clearing members with the information needed to explain margin requirements to their end-clients.

If the cash demands created by spikes in VM could not be mitigated, the in-house counsel warned that corporates might instead reduce their hedging activities. That would undermine the stated purpose of clearing mandates and non-cleared margin rules to reduce systemic risk.

“Ultimately, if both cleared and uncleared margin requirements are made more punitive and more restrictive, and there is a small of amount of eligible collateral, then you are going to transfer the risk to another area of the market because people are going to be priced out of the hedging market and just essentially find it more of a risk to be hedged than unhedged,” said the in-house counsel.

Editing by Philip Alexander