Streetwise Professor

June 8, 2011

There *Is* an Echo in Here

Filed under: Clearing,Derivatives,Economics,Financial crisis,Politics,Regulation — The Professor @ 8:33 am

Yes, there definitely is an echo.  The BIS has released a paper that, er, echoes several SWP themes.  Most notably, the paper by Daniel Heller and Nicholas Vause notes that variation margin calls can lead to substantial demands on market liquidity.  In high volatility environments, the liquidity needed to fund variation margins would represent over 28 percent of G14 dealer cash and cash equivalents on one day out of 200 for interest rate swaps alone.  CDS margin calls could also result in a substantial cash drain on dealers.

It should also be remembered that these kinds of events are likely to be associated with (either caused by, or causing) tightness in funding markets.   It should also be noted that the BIS just looks at dealer variation margin payments.  In stressed market conditions, however, other market participants—including hedge funds, broker-dealers, and depending on the kinds of regulations that are adopted, certain derivatives end users—will also be subject to big margin calls.  This places further demands on liquidity.   These hedge funds and others would be looking to banks—including notably the big dealers—for funding.  This could lead to major liquidity shortages, and as the BIS notes, central banks are likely to need to inject liquidity either to banks or CCPs in order to mitigate these shortages.  [The zero sum nature of these margin calls raises some interesting issues.  I am currently noodling through some models based on the Holmstrom-Tirole setup to work through these issues.]

It would not be correct to suggest or imply that this is a problem associated with clearing alone.  Many OTC derivatives trades—including trades between dealers—are marked to market daily, and require variation margin payments.  Thus, big price moves would create funding demands to meet margin calls even in the absence of central clearing.  However, note that the increase in initial margins that clearing mandates, and margining mandates for non-cleared derivatives, will increase funding and liquidity needs beyond the level that would be required without these mandates.  Add to this Basel III liquidity requirements, and the heightened potential for liquidity crunches in the new environment are clearly manifest.

The BIS paper also quantifies the potential burden that variation margin payments could place on CCP default funds in the event of a default by one or more clearing members.  It concludes:

With a probability of one in 10,000, non-margin resources at risk from the failure of one particular dealer, two particular dealers or any dealer with sufficiently adversely affected portfolios would respectively be 20%, 37% and  42% of total initial margins for IRS, and 36%, 46% and 65% of total initial  margins for CDS. If prevailing levels of volatility were high, these figures would  equate to $21 billion, $39 billion and $44 billion for IRS, and $13 billion,  $16 billion and $23 billion for CDS.

These are big numbers, and indicate the kinds of resources that CCPs must have on tap to deal with defaults.

Note especially that these resources are likely to be contributed by major banks—which means that major defaults will impact non-defaulting bank balance sheets, contrary to the facile claims that clearing would put a firewall between derivatives defaults and major banks.  It also has implications for the appropriate capital charges for default fund exposures.

The BIS report quantifies roughly the economies of scope that result from clearing (another common theme here), and argues that these economies will permit more economical use of capital.  Left unstated is an important point that I’ve emphasized—but which is too often ignored.  Specifically, if clearing improves capital efficiency, it will reduce the marginal cost of trading derivatives, which will lead to an increasing scale of derivatives trading—and hence greater total counterparty risk.  Even if one assumes that CCPs allocate a given amount of counterparty risk more efficiently than is the case in the bilateral markets (an arguable assumption), it is not evident that this improvement in the allocation of risk would more than offset the effect of an increase in the total amount of risk to be allocated.  This issue deserves far more attention than it has received—which is not a hard statement to make, given that it has received almost no attention whatsoever.

The BIS report also discusses procyclicality of margins—another echo.  This is an extremely important—and extremely vexing—matter.  It is one about which CCPs are quite sensitive.  I don’t have any easy answers, except to say that (a) it is a real issue that deserves attention, (b) it is by no means obvious that CCPs have the appropriate information or incentive to take into account the knock-on effect of margin changes, and that (c) mechanical, value-at-risk driven approaches like those proposed by CFTC, SEC, and the Fed are the worst way to set margins.

Today’s WSJ carries an article related to procylicality in which I am quoted.  The issue is getting attention, and is not going away.  It is not going away in part because it is a very knotty problem.  So I am certain that the echoes will continue for some time to come.

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