The World Federation of Exchanges (WFE) has suggested that central counterparties (CCPs) and exchanges could not have prevented the COVID-19 related spikes in margin requirements.
There is an argument that one of the reasons for the large margin calls observed during the March events is that margin models “seem to have underestimated market volatility, in part because they have relied on a short period of historical price movements from tranquil times”.
It was suggested that these CCPs had to catch up and increase margins at the wrong time, squeezing liquidity when it was most needed.
WFE’s new research working paper on the Procyclicality of CCP Margin Models highlights that this belief seems to be based on the idea that shorter lookback periods are dominated by tranquil times and are therefore unable to capture the suddenly rising counterparty credit risk in times of stress, and that with a long look-back period, IM models “are more likely to include high levels of historical volatility – and volatility spikes would be less likely to surprise”.
The industry group explains that such arguments are flawed because they fail to distinguish between conditional and unconditional volatilities and to take into account the diluting effects of larger samples.
The research observes that the relation between the ability to capture a sudden rise in risk and the length of the lookback period tends to be precisely the other way around: shorter lookback periods are better to capture sudden spikes in risk.
While WFE says it is true that a longer lookback will be more likely to capture a more diverse set of conditions, in a historical simulation model, the ability to capture a sudden increase in risk will tend to decrease as the sample increases.
This is because new observations will have lower weight and the less valid the assumption will be, according to WFE and research shows that since volatility changes through time, this implies less ability to capture conditional volatility.
WFE says: “There is limited gain in having a correctly calibrated and minimally procyclical IM model if other parts of the system are too sensitive to or inadequately prepared for a sharp increase in risk (and, consequently, in margin calls), let alone to one of the magnitude seen during the March 2020 events. While the need for a systemic view is far from new, its importance is being increasingly recognised by regulators.”
The paper highlights that procyclicality mitigation tools that CCPs have are unable to eliminate all traces of procyclicality, and banks concerned at resulting funding stresses should instead pay closer attention to their liquidity management practices.
While the “procyclicality mitigation tools that CCPs have put in place are one layer of defence, other layers are needed”, indicates WFE.
This includes market participants ensuring their liquidity management strategies take account of the possibility that margin calls and requirements may rise significantly during periods of market stress, or liquidity-focused macroprudential stress tests to help manage systemic liquidity risk.
Margin requirements are a fundamental part of CCPs' management of counterparty risk, ensuring that the exposure to a failing member will be sufficiently collateralised 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.
As well as this, 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 collateralised at all times, and by the need to keep central clearing economically efficient.
“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,” says WFE.
As post-Lehman's regulations recognised, WFE affirms this should be carried out by a neutral third party, rather than being left in the hands of private participants with risk positions.
WFE’s paper notes that choosing and calibrating IM models so that they provide the expected coverage but with the least possible procyclical behaviour is undoubtedly an effective contribution to financial stability.
Nandini Sukumar, CEO of the WFE, comments: “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, highlights: “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,” he adds.
In July 2020, WFE called for a “careful and considered” approach in changing resolution arrangements at CCPs to avoid damaging stability and increasing systemic risk.
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