How to stop margin calls from blowing up markets

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6 minute read

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LONDON, May 23 (Reuters Breakingviews) - Margin makes the financial system safer, but margin calls can be problematic. That’s the paradox regulators, traders and clearing houses are grappling with in the wake of the March 2020 panic and recent volatility in energy prices. The fix is to boost margin during good times, even if that makes trading costlier.

The structure of today’s 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 to the brink of collapse. Policymakers responded by forcing banks to clear more derivatives through central counterparties (CCPs). These bodies, typically owned by bourses like the London Stock Exchange, stand between buyer and seller and protect either party if the other blows up.

The reforms were a success. By March 2020, 60% of credit default swaps and 80% of interest rate swaps were centrally cleared, according to the Bank of England, compared with 10% and 40%, respectively, in 2008. The amount of collateral held by members of the International Swaps and Derivatives Association increased by $820 billion, or 180%, between 2006 and 2014, according to a review by the Financial Stability Board.

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DASH FOR CASH

When the global pandemic caused wild swings in financial markets in the spring 2020, and when Russian President Vladimir Putin’s invasion of Ukraine did the same two years later, no one worried about bilateral derivatives exposures bringing down systemic banks. But the episodes exposed an enduring weakness: the tendency of volatile markets to trigger margin demands which add to the instability.

The collateral underpinning most derivatives contracts has two components. The first is initial margin, or the baseline level that’s supposed to cover the risk of default. It’s typically a percentage of a trader’s exposure – usually between 3% and 12% for a futures contract, according to the CME Group. The second type is variation margin, which is usually paid daily to keep CCPs’ collateral buffers relatively stable as markets fluctuate.

Both rise sharply during a panic: CCPs increase initial margin requirements as volatility rises, while variation margin is based on the daily profit or loss in a position. A trader with a losing bet is therefore required to keep handing over more cash as the market moves against them.

This was a feature of markets before 2008. But the growing role of CCPs has two effects. First, they tend to ask for more collateral than banks did in the pre-crisis world. Second, when a CCP hikes its initial margin requirement this applies to everyone in the market, meaning cash calls are synchronised.

For example, the overall initial margin posted at CCPs rose by $300 billion, or 40%, in the weeks up to mid-March 2020, according to a Bank for International Settlements (BIS) study. The figure for bilateral derivatives barely changed, based on figures cited by BoE Deputy Governor Jon Cunliffe.

A similar dynamic played out when the Ukraine invasion sent energy prices soaring. The European Federation of Energy Traders (EFET) said in early March that the initial margin one large energy producer had to post with CCPs rose to 6 billion euros, from 1 billion euros last summer, even though its underlying position was unchanged. The same energy trader also faced daily variation margin payments of 500 million euros, compared with 50 million euros previously.

It’s logical that CCPs ask for more collateral during a panic: that’s when defaults are most likely. The problem is that margin calls seem to have made things worse. In March 2020, for example, a so-called “dash for cash” saw investors liquidate even prime money-market funds and U.S. Treasury securities. The BoE’s Cunliffe reckons this was partly because investors needed cash to meet margin calls on derivatives.

Meanwhile, surging energy and commodity prices this year forced energy traders who were short the market to post more collateral and take long positions to cover their losses. That drove prices higher, forcing yet more margin calls. The most extreme example was nickel trading on the London Metal Exchange which pushed broker-dealers to the brink of failure and forced the LME to cancel some trades.

CLEARING HOUSE

The question is how to prevent a repeat. One option is to accept that higher collateral requirements are inevitable in a panic, and that central banks may have to step in to stop a liquidity crunch from becoming something worse. That’s what happened in 2020, when rate-setters in the Group of 10 leading economies collectively expanded their balance sheets by $8 trillion. The BIS recently released a publication mulling the various tools central banks have at their disposal in these cases. Yet the danger is that safety nets encourage hedge funds and others to load up on risk, in the knowledge that central banks will provide a buffer if margin calls spike.

An alternative idea is to make sure CCPs’ clients are better prepared for margin calls. A BIS analysis found “significant dispersion” in the size of the increases in initial margin increases across, and within, asset classes, implying that CCPs use different models. However, enforcing uniformity and transparency wouldn’t address the underlying problem that margin calls tend to spike when liquidity is scarce.

The least-bad solution is for CCPs to demand more collateral requirements during normal times, reducing the need for big increases. The Futures Industry Association, whose members include banks and brokers, in late 2020 proposed measures like introducing margin floors to stop collateral levels from falling too low.

There are downsides. Higher margin makes using derivatives more expensive, potentially benefitting big traders relative to smaller ones. It also doesn’t necessarily prevent CCPs from asking for more cash in times of stress.

The key point, however, is that rampant margin calls have intensified a financial panic twice in as many years, with central banks effectively bailing out markets in 2020. That’s better than in 2008, when taxpayers had to step in. But the problem of margin calls remains unsolved. It’s worth trying to fix it before the next inevitable crisis.

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(The author is a Reuters Breakingviews columnist. The opinions expressed are his own.)

CONTEXT NEWS

- Central counterparty (CCP) clearing houses should consider asking clients for more collateral during good times to reduce the risk of destabilising margin calls during a financial panic, a Bank of England official said on May 19.

- Christina Segal-Knowles, who is the UK central bank’s executive director for financial markets infrastructure, was speaking at an event hosted by the European Association of CCP Clearing Houses.

- “By design, post-crisis reforms mean that in events of market turmoil losses are crystallised promptly and risk is repriced. But as we have seen in 2020 and again in 2022 this can mean very sharp strains on liquidity in parts of the system,” she said.

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Editing by Peter Thal Larsen and Streisand Neto

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