BIS report urges derivatives clearing review after margin surge

4 min read
Christopher Whittall

Regulators should reassess aspects of the financial plumbing designed to prevent risks from derivatives markets torpedoing the wider financial system, according to a report from the Bank for International Settlements, following a sharp jump in margin calls for the largest banks involved in these markets during the recent sell-off.

Derivatives clearing houses, also known as central counterparties, increased deposits at the Federal Reserve to more than US$270bn in March from about US$70bn amid violent swings in financial markets, the report said, reflecting a sharp jump in margin posted by clearing banks.

Large US commercial banks also doubled their reserves of cash to US$1.5trn around this time, possibly in anticipation of further substantial margin calls.

The BIS Bulletin said the margin models of some CCPs appear to have underestimated the market volatility, causing them to increase margins “at the wrong time, squeezing liquidity when it was most needed".

“The interaction of CCPs with clearing member banks is critical,” the report authors wrote, referring to what they called the “CCP-bank nexus”.

"Importantly, actions that might seem prudent from an individual institution's perspective, such as increasing margins in a turmoil, might destabilise the nexus overall.”

CCPs act as middlemen in derivatives trades, preventing losses cascading through the financial system if one of the parties to the trade defaults. Regulators forced large tracts of the US$559trn derivatives market through clearing houses following the 2008 financial crisis to reduce systemic risk.

RESILIENT

The BIS, which is owned by a group of 62 central banks, regularly publishes analyses on the financial system that help inform policymaking.

Overall, the authors of the report said “CCPs remained resilient [during the turmoil], vindicating the post-crisis reforms that incentivised central clearing”.

Still, they highlighted "large margin calls" from CCPs, which they said strained the liquidity positions of large dealer banks.

“The resulting bank liquidity squeeze might be particularly harmful now, as corporates and households rely on banks for funding,” the authors wrote.

The report noted that margin increases are a feature of stressed markets, as traders sitting on mark-to-market losses are required to post collateral known as variation margin.

But the authors mostly focused on recent increases in initial margin requirements - the collateral that derivatives traders must stump up at the beginning of a transaction to cover any future expected losses. Clearing houses could look to increase initial margin during a crisis if they are worried that levels are too low.

“This seems to have happened during the turmoil,” the report said, highlighting the steep rise in CCP deposits at the Fed.

Elsewhere, initial margin requirements for major US equity futures have doubled since March, the report said, while Asian CCPs have also raised requirements significantly.

“The large margin calls were significant, because clearing rates have increased substantially since” the 2008 financial crisis, the report said.

HIGH STAKES

The stakes are high for supervisors to find the right balance in the regulatory framework given derivatives clearing is highly concentrated in a handful of institutions.

Just one CCP handles more than 90% of cleared interest-rate derivatives, while another handles more than 90% of cleared credit derivatives, the report said. Meanwhile, the five largest clearing banks together account for more than half of all derivatives positions at CCPs.

“CCPs and banks form a nexus,” the report's authors said. “Whether CCPs will amplify or absorb further shocks hinges on their interdependencies with large dealer banks.”

They suggest regulators use the "ample" data from recent events to analyse the trade-off in margin-setting guidance.

One “macroprudential” approach would be to limit collateral increases in times of stress by, for instance, requiring higher margin levels when markets are tranquil, the report said.