The European Systemic Risk Board (ESRB) has today published a report on mitigating the procyclicality of margins and haircuts in derivatives markets and securities financing transactions. The report expands on the work of a previous ESRB report published in 2017 by providing new analysis and setting out possible policy options to address systemic risks arising from the procyclicality associated with margin and haircut practices.
The policy options in consideration are as follows: the pass-through by central counterparties of any intraday variation margin collected in the course of the same day; the introduction of initial margin floors in both centrally and non-centrally cleared derivatives markets; the reduction of risks of procyclicality in client clearing by limiting the discretion of client clearing service providers towards their clients; the introduction of adequate notice periods to changes in collateral haircuts and eligibility; the introduction of a cash collateral buffer for market participants active in centrally and non-centrally cleared derivatives markets; and the mandatory use of initial and variation margins as risk mitigation techniques in non-centrally cleared securities financing transaction markets.
Replacing haircuts with initial margins paid to default remote entities would disconnect collateral payments from counterparty credit risk. The counterparties would exchange an equal value of cash and collateral, with the daily exchange of variation margin ensuring that there is no build-up of unsecured exposures. The repo transactions would then always be at a zero haircut, and initial margins would instead protect both counterparties against the default of the other counterparty. This means that initial margins would need to be held in segregated and bankruptcy-remote fashion, separated from the assets of the counterparties collecting the collateral. This procedure still allows the reuse of SFT collateral assets, other than those posted for margining purposes. The daily exchange of variation margin entails that the initial margins would only need to protect the cash lender for the period it takes to sell the collateral after a counterparty default. In long-term repos, the initial margin required would therefore be lower than the corresponding haircut, while achieving the same level of protection for the cash lender (collateral taker).