OFR article on initial margin in centrally cleared swaps: do the CCPs really get it right?

A recent article published by the Office of Financial Research, Hidden Illiquidity with Multiple Central Counterparties, May 7, 2015, by Paul Glasserman, Ciamac C. Moallemi and Kai Yuan caught our eye. It was one of those things that seems so obvious when you read it, but gets missed in practice.

The article deals with initial margin on centrally cleared swaps. They ask the question: are CCPs collecting enough IM to account for potential illiquidy should the CCP have to replace large positions?

CCPs may hike up IM based on size of positions. But that just acts as an incentive for members to spread around their positions. The author’s quoted ICE Credit Clear:

“…For portfolio/concentration risks, large position requirements, also known as concentration charges, apply to long and short protection positions that exceed predefined notional threshold levels. The concentration charge threshold reflects market depth and liquidity for the specific index family or reference entity. Positions that exceed selected thresholds are subject to additional, exponentially increasing, initial margin requirements. The accelerated initial margin creates the economic incentive to eliminate large positions….” [Emphasis added]

The main problem the authors cite is that when positions are distributed, no one is really tracking if there is enough margin should that member default across CCPs. From the report:

“…Because of limited liquidity in the market, the replacement cost is likely to be larger for a large position by more than a proportional amount. If the CCP needs to replace a $1 billion swap, it may find several dealers willing to trade. But if it needs to replace a $10 billion swap, it may find few willing dealers, and those that will quote a price may command a premium to take on the added risk of the position. The consequences of this liquidity effect on margin are the focus of this paper…”


“…The same dealer may have similar positions at other CCPs. If the dealer goes bankrupt, all CCPs at which the dealer participates need to close out their contracts with the dealer at the same time. The impact on market prices is driven by the combined effect from all CCPs. If each CCP sets its margin requirements based only on the positions it sees (as appears to be the case in practice), it underestimates the margin it needs. This is what we call hidden illiquidity…”

The authors are suggesting that knowledge of the positions across CCPs should be aggregated and each CCP should adjust the IM they charge any particular member based on the aggregate amount. The underlying assumption is if a clearing member defaults on one CCP, the member will default across all their CCPs.

“…If the dealer fails, all CCPs through which it trades will need to replace the dealer’s positions at the same time. Their liquidation costs will be driven by the total size of the dealer’s positions across all CCPs. If each CCP bases its margin requirements solely on the trades it clears, without considering trades by the same dealer at other CCPs, it will underestimate the margin it needs to cover liquidation costs…”

But sharing this kind of data won’t happen willingly. CCPs compete with each other and clearing members aren’t going to be thrilled with so much information floating around. The authors also suggested that clearing members be asked to periodically provide prices and quantities they would be committed to buy if another member defaulted. That kind of hard commitment seems unlikely, but derivatives dealers might provide indicative prices they would replace positions scaled by the size of the trade. That could be a way to get a feel for the illiquidity discount.

Why aren’t CCPs taking this into consideration already? Was it simply not considered?

“…Clearing regulations require CCPs to back test their margin requirements against historical data. But this simple result implies that a properly calibrated margin model will understate the required margin, unless each CCP considers the simultaneous effects of other CCPs in its analysis. Although they are lengthy and detailed, procedures for swap CCPs adopted by the Commodity Futures Trading Commission (2011) and the European Commission (2013) do not address the need to consider the effect of a member’s default at other CCPs…”

When the underlying derivatives are themselves illiquid, this exacerbates the problem. We wrote about this in our May 5th post “CME gets ready to add swaptions to central clearing. Not everyone is happy.”

From the OFR article:

“…Swaptions and inflation swaps have been proposed for central clearing but are far less liquid than standard interest rate swaps. Even among index CDS, off-the-run indexes are significantly less liquid than their on-the-run versions. Each index CDS trades at multiple maturities, and liquidity is much lower at maturities other than five years…”

Where are the regulators on this? Not involved, so it would seem.

“…Responding to comments on its proposed rules, the CFTC specifically declined recommendations requiring that position concentration be factored into margin calculations, leaving the matter to the discretion of each CCP; (see Commodity Futures Trading Commission, 2011, p. 69366)…”

This is one of those issues that seems so obvious. Perhaps trade repositories could be utilized? In a crisis, when the stress gets worse because of uncertainty about the how big positions are, understanding consolidated positions could be a big help.

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