Lifting the veil on margins

Key Takeaways

• Extreme bouts of volatility exposed the cracks in post-GFC derivatives legislation.
• Regulators are calling for new processes to bolster the resilience and efficiencies of margins.
• Technology will play a key role, especially front-to-back systems that offer risk controls and scenario testing.

Ever since the global financial crisis (GFC), margin transparency has been a key goal among policymakers. However, the market turmoil and liquidity squeezes in recent years have prompted regulators to revisit their roadmap to focus on bolstering defences and enhancing efficiency.

The latest International Swaps and Derivatives Association (ISDA) survey underscores the critical risk mitigation role that margin plays in the world’s financial markets. The survey revealed that in 2023, $392.2 billion in initial margin (IM) was posted by all market participants for cleared interest rate derivatives (IRD), and single-name and index credit default swaps (CDS).  Meanwhile, an additional $1.4 trillion of IM and variation margin (VM) was collected by 32 leading derivatives players for their non-cleared derivatives exposures.

There has been a plethora of legislation since 2008, the most significant being the collective Basel Committee for Banking Supervision (BCBS) and the International Organisation of Securities Commission (IOSCO) push for central clearing . This encompasses the uncleared margin rules (UMR), which involve the mandatory exchange and segregation of IM on non-cleared derivatives trades.

IM, which is collateral collected and/or posted to reduce future exposure to a given counterparty, is a relatively new concept. It’s been a steep leaning curve, especially for smaller to medium-sized firms that have never had to go down this road. This is not the case with VM, which is paid daily from one side of the trade to the other, to reflect the current market value of the trade.

Building a better fortress

Although the post-GFC reforms were designed to fortify financial market resilience, cracks appeared due to a confluence of events such as COVID-19, the Ukraine war, higher interest rates, and political mishaps. The most notable of the latter being the infamous Liz Truss mini-budget, which upended markets across the globe and almost brought the UK gilts market to the brink of disaster.

These views were reflected in Acuiti’s Clearing Insight report Q3 2024. The report noted that while central clearing of derivatives provides investors with a means to both speculate and hedge in a safer environment, extreme outbreaks of volatility over the past five years exposed potential weaknesses in market structure. This is particularly the case with the size and unpredictability of margin calls that have raised fears of potential risk in the financial system.

These concerns motivated BCBS, the Committee on Payments and Market Infrastructures (CPMI), and IOSCO to develop a list of new processes to strengthen the central clearing of derivatives ecosystem in times of market stress. These include expanding access to central counterparty (CCP) simulation tools, improving measurements of IM responsiveness, refining governance frameworks, and allowing margin model overrides. Additionally, they call for clearing members to provide clients with greater visibility into potential margin calls.

Filling in the blanks

On the whole, ISDA supports the recommendations – particularly the margin simulators, because they allow firms to estimate margin under a variety of conditions. It also agrees that CCPs should make margin model documentation available to allow clearing members and clients to understand key aspects of their models. This should cover calibrations of key model parameters and logic used for the calculation of any additional CCP margin components.

However, ISDA believes more work is required in certain areas, such as CCP disclosure of their approach to procyclicality, and the risk management tools they use to dampen market fluctuations. The trade group also said that buy-side and sell-side working group members would welcome more stability in IM, even though that could mean higher margin levels during benign periods.

The devil, of course, is always in the detail. But, as the Acuiti report notes, even the basic proposals will require a major increase in transparency obligations, including transparency in risk management. It noted that while these measures will boost the resilience of derivatives markets, the operational lift required to realise them is significant and, its research found, potentially under-appreciated in the market.

Of course, technology will play a significant role. There are already innovative tools in the market that can help boost margin transparency. Among the most notable are front-to-back integrated systems that not only monitor and control risk in real-time, but also offer scenario testing, behaviour analysis, and the ability to replicate margins calculated by CCPs across a broad spectrum of exchanges.

Another key development is increasing the use of non-cash collateral, such as equities. This would provide a rounder cushion to meet collateral calls in periods of volatility without having to stump up more cash or liquidate positions.