The Covid-19 pandemic led to market turmoil in mid-March. Large price movements prompted large margin calls from central counterparties (CCPs). This strained the liquidity positions of large dealer banks. Banks also hoarded liquid assets, possibly in anticipation of large margin calls. This exacerbated the liquidity squeeze.
Nevertheless, CCPs remained resilient, vindicating the post-crisis reforms that incentivized central clearing. The procyclicality of leverage embedded in margining models might have played a role in the events of mid-March. These margin models are critical because they underpin the management of counterparty credit risk. Margin models of some CCPs seem to have underestimated market volatility, in part because they have relied on a short period of historical price movements from tranquil times. These CCPs had to catch up and increase margins at the wrong time, squeezing liquidity when it was most needed.
Going forward, the interaction of CCPs with clearing member banks, named the CCP-bank nexus by researchers from the Bank for International Settlements, is critical. Importantly, actions that might seem prudent from an individual institution’s perspective, such as increasing margins in a turmoil, might destabilize the nexus overall. Therefore, central banks need to assess banks and CCPs jointly rather than in isolation.
Key takeaways:
- During the Covid-19-induced financial turbulence, central counterparties (CCPs) issued large margin calls, weighing on the liquidity of clearing member banks.
- In spite of the turbulence, CCPs remained resilient, as intended by the post-crisis reforms of financial market infrastructures.
- Higher margins should be expected during heightened turbulence, but the extent of the procyclicality of margining is the consequence of various design choices.
- Systemic considerations call to examine the nexus between banks and CCPs. Therefore, when thinking about margining, central banks need to assess banks and CCPs jointly rather than in isolation.