LONDON (Reuters Breakingviews) – Margin makes the financial system safer, but margin calls can be problematic. This is the paradox that regulators, traders and clearinghouses are grappling with in the wake of the March 2020 panic and recent energy price volatility. The solution is to increase the margin during good times, even if it makes trading more expensive.
The structure of the current global derivatives market dates back to 2009. The previous year, an opaque web of bilateral over-the-counter (OTC) contracts, such as credit default swaps, dragged systemically important lenders into the edge of collapse. Policymakers by forcing banks to clear more derivatives through central counterparties (CCPs). These bodies, usually owned by exchanges like the London Stock Exchange, stand between buyer and seller and protect either party if the other blows up.
The reforms were a success. As of March 2020, 60% of credit default swaps and 80% of interest rate swaps were centrally cleared, according to the , compared to 10% and 40%, respectively, in 2008. The amount of collateral held by members of the International Swaps and Derivatives Association grew by $820 billion, or 180%, between 2006 and 2014, according to research by .
DASH FOR MONEY
When the global pandemic caused wild swings in financial markets in the spring of 2020, and when Russian President Vladimir Putin’s invasion of Ukraine did the same two years later, no one worried about bilateral exposures. to derivatives bringing down systemic banks. But the episodes revealed a lingering weakness: the tendency for volatile markets to trigger margin demands that add to instability.
The collateral underlying most derivative contracts has two elements. The first is the initial margin, or the reference level supposed to cover the risk of default. This is usually a percentage of a trader’s exposure – typically between 3% and 12% for a futures contract, depending on the . The second type is variation margin, which is typically paid daily to keep CCP collateral buffers relatively stable when markets fluctuate.
Both increase sharply during a panic: CCPs increase initial margin requirements as volatility increases, while variation margin is based on a position’s daily profit or loss. A trader with a losing bet is therefore bound to keep handing over more money as the market moves against him.
This was a feature of the markets before 2008. But the growing role of central counterparties has two effects. First, they tend to charge more than banks in the pre-crisis world. Second, when a central counterparty increases its initial margin requirement, this applies to all market participants, which means that fund calls are synchronized.
For example, the overall initial margin posted on CCPs increased by $300 billion, or 40%, in the weeks to mid-March 2020, according to research (BIS). The bilateral derivatives figure barely changed, based on figures cited by the BoE Deputy Governor.
A similar dynamic occurred when the invasion of Ukraine drove up energy prices. The European Federation of Energy Traders (EFET) said in early March that the initial margin a major energy producer had to post with CCPs had risen to €6 billion from €1 billion last summer. , even if its underlying position was unchanged. The same energy trader also faced daily variation margin payments of €500m, up from €50m previously.
It is logical that CCPs require more guarantees in the event of a panic: this is when failures are most likely. The problem is that the margin calls seem to have made matters worse. In March 2020, for example, a so-called “race for cash” saw investors liquidate even blue-chip money market funds and US Treasury securities. The BoE’s Cunliffe believes this was partly because investors needed cash to meet margin calls on derivatives.
Meanwhile, soaring energy and commodity prices this year have forced energy traders who were short in the market to post more collateral and take long positions to cover their losses. This drove prices up, forcing even more margin calls. The most extreme example was nickel trading on the London Metal Exchange, which pushed brokers to the brink of failure and forced the LME to cancel some trades.
The question is how to prevent a repetition. One option is to accept that higher collateral requirements are unavoidable in the event of a panic and that central banks may have to step in to prevent a liquidity crisis from worsening. That’s what happened in 2020, when policymakers in the Group of 10 major economies collectively expanded their balance sheets by $8 trillion. The BIS recently published a publication describing the various tools available to central banks in these cases. Yet the danger is that backstops encourage hedge funds and others to take on the risk, knowing that central banks will provide a buffer if margin calls increase.
An alternative idea is to ensure that CCP clients are better prepared for margin calls. One BIS found “significant dispersion” in the magnitude of initial margin increases across and within asset classes, implying that CCPs use different models. However, applying uniformity and transparency would not solve the underlying problem that margin calls tend to increase when liquidity is scarce.
The least bad solution is for CCPs to require more collateral in normal times, which reduces the need for large increases. The Futures Industry Association, whose members include banks and brokers, ended 2020 on measures such as the introduction of margin floors to prevent collateral levels from falling too low.
There are disadvantages. A higher margin makes it more expensive to use derivatives, which potentially benefits larger traders over smaller ones. Nor does it necessarily prevent PCCs from asking for more money in times of stress.
The key point, however, is that creeping margin calls have intensified a financial panic twice in as many years as central banks effectively bailed out markets in 2020. That’s better than 2008, when taxpayers had to intervene. But the issue of margin calls remains unresolved. It’s worth trying to fix it before the next inevitable crisis.
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– Central counterparty clearinghouses (CCPs) should consider asking customers for more collateral during good times to reduce the risk of destabilizing margin calls during a financial panic, a Bank official said. England on May 19.
– Christina Segal-Knowles, the UK central bank’s executive director for financial market infrastructure, was speaking at an event organized by the European Association of CCP Clearing Houses.
– “By design, post-crisis reforms mean that in the event of market turbulence, losses quickly crystallize and risk is reassessed. But as we’ve seen in 2020 and again in 2022, that can mean very high liquidity pressures in parts of the system,” she said.
(Editing by Peter Thal Larsen and Streisand Neto)
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