Margin Rules Solve for One Risk…And Exacerbate Another: BIS

A study from the Bank for International Settlements (BIS) finds that while margin rules have helped reduce counterparty credit risk, they have exacerbated the level of turbulence around liquidity events. It finds that during the UK mini-budget crisis in September 2022, potential margin breaches peaked at just shy of £700 million.

The article, in the latest BIS Quarterly Bulletin, observes that an increasing share of derivatives transactions is subject to margin requirements, with those for centrally cleared instruments set by central counterparties (CCPs) and those for uncleared ones set by regulatory standards. It adds, however, “These requirements have been effective in meeting their primary objective – reducing counterparty credit risk, however, in recent periods of large shocks and bouts of market turbulence, margin surges boosted counterparties’ demand for liquidity exactly when the supply was short, in some cases exacerbating the turbulence.”

This article analyses how swings in liquidity demand reflect central clearing margin requirements, paying particular attention to aspects of the underlying model. Using data that estimates margin requirements on hypothetical trades of interest rate swaps (IRS) at LCH SwapClear, it focuses on two episodes: the Covid–19 shock of March 2020 and the UK “mini” budget turmoil in September 2022. “We show that a large component of the calibration of margin requirements – namely one reflecting market developments observed immediately before the time of calibration – is at the root of destabilising dynamics,” the report states. “A stronger precautionary component in the underlying model would dampen these dynamics but may reduce centrally cleared activity.”

Required margin amounts – realised variation margin (VM) in excess of the initial margin (IM) held by CCPs – underwent “exceptional swings” during the two periods studied. In February/March 2020, when the pandemic hit in full force, market volatility rose dramatically, resulting in sharp increases in both the overall amounts of the VMs exchanged between counterparties and the required IM. The largest daily VM paid to SwapClear reached $26 billion in Q1 2020, and IM increased by $28 billion over the same period, the study finds. Both of these values were 40% higher than the previous records, the BIS says, with SwapClear witnessing a potential margin breach as high as £558 million in Q1 2020, which was roughly equal to three times the largest value that had yet been recorded (in Q3 2015). IM again rose sharply during the bout of turbulence that followed the UK mini-budget announcement in September 2022, and potential margin breaches peaked at £698 million.

To understand the role of the underlying model in such IM developments, the study considers two hypothetical positions, for which it can derive margin requirements while fixing the trading volume. “In their respective periods of stress, both positions incurred market losses that necessitated substantial VM payments,” the paper states. “In each case, our simulations indicate that the VM level was higher than the concurrent IM, i.e. there was a potential margin breach.

“Subsequently, the required amount of IM surged, suggesting that the shocks underpinning the VM payments materially affected the implications of the IM model, even if with a lag of a few days,” it continues. “This surge reinforced the liquidity needs of entities holding the positions we consider, as it came on the heels of VM payments. Such needs generate destabilising dynamics when they arise during market stress, i.e. when they are procyclical.”

The article concludes, “The message of our stylised exercise is clear: if policymakers wish to mitigate the perverse effects of sharp adjustments to IM in times of market stress, they need to beef up its precautionary component, i.e. the SVaR floor, in tranquil times.

“Of course, raising this component means that the evolution of IM would reflect the current market environment less accurately, and the generally higher IM would increase the cost of entering derivatives positions,” it adds. “This may push activity to the less transparent bilateral markets or have participants shun derivatives, leaving some risks unhedged. From a financial stability perspective, the trade–offs between reducing margin procyclicality and reducing activity in centrally cleared derivatives call for a careful assessment and require a system–wide regulatory approach.”