For further information, please visit the White & Case Coronavirus Resource Center.
At a Glance
The risk management frameworks, systems and margin models of Central Counterparties (CCPs) across the globe have been tested by huge swings in market volatility over recent months during the current pandemic. Their models and parameters have broadly worked as designed and adapted quickly to market conditions. But, questions are being asked by regulators and cleared swaps market participants about recent CCP margin hikes and their inter-relation with the loss-absorbing layers in a CCP's default waterfall. This article summarises the issues.
The G20 had the right idea in 2009
In response to the global financial crisis, the G20 announced in 2009 that all standardised OTC derivatives should be cleared through CCPs in order to mitigate systemic risk. With derivatives clearing mandates now implemented by regulators and supervisors in many jurisdictions, the current pandemic has tested CCPs' risk management frameworks, systems and margin models across the globe in real time, with huge swings in market volatility seen over recent months.
The Financial Stability Board (FSB) in its 15 April 2020 interim report1 "COVID-19 pandemic: Financial stability implications and policy measures taken" notes that CCPs have functioned well, despite the challenging external financial and operational conditions, including huge surges in cleared swap volumes. Its list of the elements critical for CCP resilience includes CCPs' risk management frameworks, initial margin (IM) models that are correctly calibrated and are not excessively procyclical, and a sufficient default waterfall in the CCP's rulebook with multiple loss-absorbing layers. It also flags that greater interconnectedness between banks and non-banks such as CCPs warrants particular attention.
CCPs themselves report2 that their regular fire drills and business continuity planning have served them well in dealing with the pandemic. Their models and parameters have broadly worked as designed and have ticked up to adapt quickly to recent market conditions. They have carefully monitored for margin breaches where the margin posted is not enough to cover a cleared derivative's daily change in value. They have also managed the orderly close-out of the very few clearing participant defaults reported to have occurred, using the defaulter's own IM with no need to go down the other layers in the default waterfall or to use the CCP's own skin-in-the-game capital layer. So at first glance the ‘defaulter pays' CCP IM model looks to be broadly working.
Assessing CCP margin hikes and margin breaches
But questions are being asked by regulators and market participants about some perceived asymmetries in margin hikes across different CCPs in various regions. Of course all CCP margin models need to comply with domestic regulation and global financial market infrastructure (FMI) standards3: they must be sufficiently risk-sensitive and not cause procyclicality by amplifying already stressed markets. It was reported that clearing participants themselves had raised concerns about the impact on procyclicality and the ‘defaulter pays' model when a CCP recently proposed the pan-product application of IM multipliers to all clearers across the board in an initial, knee-jerk response to current high levels of volatility.
The US Commodity Futures Trading Commission (CFTC) issued a staff letter4 in mid-May reminding CCPs, trading venues and clearing members to prepare for some swap trades experiencing pricing volatility during the pandemic, with clearing members asked to monitor customer accounts to ensure that appropriate levels of IM are being collected. Some buyside firms have been surprised to find themselves tapped by their clearing members for intra-day margin for the first time.
Also in mid-May, two staffers at the Bank for International Settlements (BIS) produced a bulletin5 highlighting CCPs' large margin calls during the COVID-19-induced financial turbulence, and the impact on bank clearing member liquidity. While noting that CCPs have remained resilient, as intended by the post-crisis global FMI regulatory reforms, and that margin hikes should be expected during periods of heightened volatility, the report states that the extent to which margin calls are procyclical is the consequence of design choices in margin models and risk management frameworks. The report concludes that regulators and supervisors need to factor in to their retrospective assessment of how frameworks held up during the pandemic, and any future FMI margin-setting guidance they might issue, the trade-off between dynamic (and potentially procyclical) margin adjustment in times of stressed markets and the precautionary application of higher margin in calmer periods. And that due to the close CCP-bank nexus, the calibration of that trade-off should use data from both CCPs and bank clearing members.
The high number of recent CCP margin breaches has also led some market participants to ask whether margin levels shouldn't be permanently higher during calmer periods by recalibrating the margin period of risk and thus bolstering the ‘defaulter pays' model. While alleviating procyclicality concerns, however, this would add to the overall cost of clearing.
Adding CCP skin-in-the-game (SIG) and other CCP capital into the mix
Since the G20 derivatives clearing mandate and subsequent volumes of cleared swaps have turned CCPs into systemically important risk hubs, regulators have turned their attention towards ensuring that a failing CCP can recover or be resolved without impacting financial stability. At the height of the global pandemic on 4 May, the FSB published long-awaited draft guidance6 addressing the treatment of CCP equity when a failing CCP is in resolution. The consultation paper sets out a framework for resolution authorities to evaluate and calibrate the exposure of CCP equity to losses in recovery, liquidation and resolution.
Its publication immediately reignited the perennial debate around the alignment of incentives between CCP equity, CCP management, clearing members and end users in the loss-absorbing default waterfall layers at these former market utilities which have become for-profit entities.
There's moral hazard risk, where CCP management might be perceived to be incentivised to let the losses fall into the deeper pockets of clearing members via their rulebook-required funded and unfunded member contributions to the mutualised default fund, without the mitigating factor of more CCP SIG being potentially mandated at different points in the default waterfall.
And clearing participants are quick to point out the bizarrely successful bypassing of CCP equity as a full loss-absorbing layer via the FSB's assumption in its Key Attributes of Effective Resolution Regimes for FMI7 of the full application of the CCP's loss allocation rulebook when deciding if a CCP participant is worse off as a result of resolution measures than liquidation and thus should get statutory compensation. That's because – due to CCPs' history as market utilities – the rulebooks generally shovel most of the losses into participants' pockets.
Adding fuel to the fire – itself partly caused by extreme volatility in oil prices in global markets in recent weeks – a working paper8 published two weeks later by two more BIS staffers, titled "Model risk at central counterparties: Is skin-in-the-game a game changer?" considered how CCPs' balance sheet characteristics impact their modelling of counterparty credit risk and thus their IM models. The paper focuses on model risk, which arises when a CCP underestimates potential credit losses in its IM model. Their conclusion:
"When a CCP's IM model fails on a large scale, the CCP could fail too, losing its skin-in-the-game capital. We find that higher skin-in-the-game is significantly associated with more prudent modelling, in contrast to profits and forms of capital other than skin-in-the-game. The results may help to inform the ongoing policy debate on how to incentivise prudent credit risk management at CCPs."
More recently, the European Systemic Risk Board (ESRB) published on 8 June9 four recommendations for action, including on CCPs' models and parameters for setting margin requirements and CCPs' policies and procedures for the acceptance and valuation of collateral and for determining prudent haircuts. It also published a report on CCP margin performance during the pandemic, noting the implications of CCP margin hikes for market participants' liquidity management, funding needs - and possibly even for their solvency if liquidity stress leads to systematic fire sales of assets. The recommendations include revisiting EU derivatives clearing rules and aim to limit the cliff effects of CCPs' and clearing members' collateral demands, enhance CCP stress test scenarios for the assessment of future liquidity needs, help CCPs and clearing members limit liquidity constraints on margin collection, and promote international standards related to the mitigation of procyclicality in the provision of client clearing services.
The next day Sir Jon Cunliffe, the Bank of England's Deputy Governor, Financial Stability, gave a speech titled "Financial System Resilience: Lessons from a real stress"10 in which he noted that the increase in IM requirements at UK CCPs during the crisis was substantial but also relatively gradual – the peak one-day increase in IM was considerably smaller than peak one-day variation margin (VM) flows through the crisis. Daily VM postings to and from UK CCPs peaked at more than £30 billion, roughly five times the daily average in January and February, while UK CCPs also collected nearly £60 billion in extra IM over the first three weeks of March. He concludes that the Bank needs to be sure that derivatives clearing and margining can adjust to sharp price changes as efficiently and smoothly as possible – and that margin calls, both between CCPs and clearing members and between clearing members and their clients, are both prudent and justified. Procyclical effects need to be dampened down as far as possible without reducing appropriate protection against counterparty credit risk. The Bank will examine whether under-calibration of margin in normal times led to ‘catch-up' margin calls during the COVID-19 stress, and if more can be done to reduce procyclicality by building larger buffers in normal times.
And on the following day the Bank posted on Bank Overground11 a short piece titled "What role did margin play during the COVID-19 shock?" which had been presented to the Financial Policy Committee in April 2020. It concludes that margin helped to ensure derivatives markets remained resilient throughout the recent market shock and also resulted in a large movement of liquidity, contributing to a ‘dash for cash' in March due to some market participants lacking buffers of cash-like assets to meet actual or anticipated margin calls. The post notes that prudent margining is an important part of risk management and is not a trade-off with liquidity risk - and that participants in derivatives markets should ensure their liquidity management strategies take account of the possibility that margin calls may rise significantly during periods of market turbulence.
It's clear that any post-pandemic assessment by bank and FMI regulators and supervisors of risk management in the derivatives clearing space will need to involve careful and empirical analyses of the granular and highly interconnected interfaces between FMIs and their financial market participants - both banks and end users, and in-country and globally - before proposing any recalibration of CCP margin or default waterfall resources.
This publication is provided for your convenience and does not constitute legal advice. This publication is protected by copyright.
© 2020 White & Case LLP