In a recent research paper, the OFR examined the problem of setting margin levels that are high enough to reduce credit exposure yet stable enough to mitigate unintended procyclicality.
“The growing use of margin requirements in over-the-counter derivative transactions reduces counterparty credit risk but may amplify shocks to the financial system through margin calls when volatility spikes,” explained Paul Glasserman and Qi Wu, the paper’s authors.
“In times of higher market volatility, price changes are larger, so the minimum level of margin required to cover potential price changes with high confidence must also be larger.”
“This dynamic can, however, have a destabilising effect on financial markets. With risk-sensitive margin requirements, a spike in volatility leads to margin calls on the firms trading through a CCP or bilaterally.”
“The increase in volatility is likely to be correlated with other indicators of market stress, in which case these firms would need to post additional collateral precisely when it becomes most difficult to raise cash or other liquid assets.”
The paper proposes shifting to ‘through the cycle’ margin levels that are less sensitive to day-to-day market conditions and therefore less prone to spike at the onset of market stress.
“The cost of this added stability is that margin levels need to be higher in quiet times and may seem unnecessarily high as memories of past volatility fade,” the authors added.
The paper also raises questions over the competence of the current EU rules regarding requirements of central counterparties adopt at least one of three suggested methods to minimise procyclicality.
“These rules are vague and therefore open to interpretation, despite the specificity suggested by the numerical values associated with the three options. The rules also fail to differentiate between features of different asset classes.”