In the run-up to the Brexit vote, many firms trading OTC interest rate swaps were understandably worried about the impact of short term market volatility on the margin that they would need to post to their clearing houses.
Our aim in this post is to share some of the analysis that we did prior to the vote, and are continuing to run on an hour by hour basis, with the objective of helping firms to assess the liquidity impact and to understand the key drivers of changes in margin.
This analysis is equally useful to collateral managers and risk analysts at banks that are direct clearing members, and buy-side firms that clear through a broker and are worried about the increased margin requirements (both initial margin (IM) and variation margin (VM)) for which they will need to source high quality assets.
Three causes of increased IM are identified and explained: Volatility rescaling, VaR scenario changes, and increasing PV01 due to falling rates. So far, changes in IM for a GBP portfolio have moved by between 5% and 10%, with further increases likely over the coming days. This is in addition to any cash VM requirements as a result of recent large market moves.
The real world impact
The following assumes that we hold a GBP interest rate swap portfolio at a major OTC clearing house. We selected a GBP portfolio as this is the currency a priori the most affected by the referendum.
Pre-referendum margin sensitivity analysis
On Thursday the referendum on the UK membership of the EU took place. On Thursday evening we ran our margin scenario tool on our reference portfolio in order to understand the impact of various rates moves on our IM. We anticipated that a potential large market move after the referendum results would be published on Friday would result in increased margin requirements. Figure 1 below was generated from the tool for our GBP portfolio and shows that a significant decrease in rates would have a significant impact on our liquidity requirements. Some of the reasons behind the impact are described in the technical appendix.
Figure 1. IM estimation for different parallel moves of the GBP curves.
Post-referendum intraday IM estimation
On Friday, the result of the referendum was obviously not as predicted. The previous graph indicates we should look out for a drop in interest rates as it would substantially increase our IM requirement at the CCP.
First look at the market at 7:00am: rates moved down sharply.
With a drop of 35 bps on the 30y GBP IRS, it is time to run our IM predictive tool to quantify the impact on IM:
- IM call for 23rd of June, computed at 4:30 pm was GBP 9.5 million;
- The first prediction for the 24th of June, with the 7:00am market level, is around 10.6 million. This is a 1 million increase (11 %), which has to be funded on Mon morning.
The market remained relatively stable during the day after the large overnight drop. Figure 2 below shows how the margin prediction for Monday (27th of June) changed through Friday (24th of June) with the market movements. Each green square represents one intraday computation. The intraday range of numbers was around 4.5%.
Figure 2. Intra-day estimates of the IM for 24-Jun-2016
The blue cross and associated dotted line represent the official 23-June IM from the CCP computed with the market at 4:30pm. The green squares represent the prediction of the 24-June IM computed with the market level at different times from 23-June to 24-June.
Post-referendum EOD margin call
On Monday 27th the margin call from the CCP arrived, with an official margin of GBP 10,271,761 – OpenGamma’s software estimated that the margin would be GBP 10,270,425 with the market level I captured at 4:30pm. On the above graph, the actual margin call is represented by the grey cross and the associated dotted grey line. This represents a day-on-day increase of 8%.
In the context of assessing the impact of volatility ex-ante, our calculation was very close. The ability to predict upcoming margin call enables optimisation of the funding strategy for the cash / government bonds required by the CCP.
We expect further margin changes over the coming days caused by Friday’s market move. All the procyclical features are linked to the 5 day Margin Period of Risk (MPoR). The volatility will continue to appear over the next 5 days, even if the market does not move anymore. We will update this blog over the coming days to show how this plays out.
Predicting upcoming CCP margin calls is critically important in periods of high market volatility. CCP margin methodologies have features specifically designed to increase the margin during these periods
Generally, IM is set to increase between 5% and 10%, due to the market volatility we have seen on Friday, but this could increase further if market volatility persists over the coming week.
For a more detailed explanation of the increase in collateral requirements, we will now look at the driving forces behind the increase in our collateral requirements:
1. Volatility rescaling
Clearing houses ensure their margin methodologies are reactive to the volatility in markets: collecting more margin in times of market stress and less margin in more stable markets. Major OTC clearing houses use Historical Simulation VaR or ES to calculate IM requirements. Their models also typically factor in a mechanism to scale historical scenarios based on current volatility. This ensures that the risk measures are responsive to changes in market volatility.
Clearing members and clients being asked to post more margin in times of stress – known as procyclicality – is closely monitored by regulators who are keen on ensuring that a market stress is not compounded by liquidity issues, with financial institutions all trying to source additional high quality assets in times of market turbulence.
A commonly used approach to compute volatility is the Exponentially Weighted Moving Average (EWMA) model, where the calculated volatility puts more emphasis on recent market movements. The historical shocks are rescaled using a ratio of the current volatility to the historical volatility from each scenario date, but the procyclical effect is reduced by scaling returns only by part of the calculated ratio. The clearing houses will be under significant pressure to balance the need for calling additional margin to cover risk, with the need to avoid contributing to volatility (procyclicality), and they have flexibility to apply discretion / subjectivity in their decision making.
As we explained in the first part of this blog, a large market movement took place between the 23rd and the 24th, which caused the volatility (and historical returns) to be updated.
Actually the pre-referendum volatility already had an impact on our IM before the 24th, as the rates went up significantly pre-referendum. Even with an unchanged rate between Thursday 23 and Friday 24, the rate change between Friday 17 and Friday 24 is enough to increase the volatility. We estimate the impact of the volatility increase to be a 4 to 5% IM increase.
2. Increase in PV01 due to fall in rates
Even in the absence of change in the historical scenarios used, the current level of rates has an impact on the IM. One standard way to define the historical scenarios is to compute the absolute rate’s change. The P/L impact of a fixed change of rate will depend on the rate level: when rates are lower, the same absolute shift of rates has a higher impact on P/L. On a 30Y swap in GBP with the market level of the 23-June, a 30 bps down in rates has an impact of around 4% on the PV01 level.
3. Change of scenarios used in VaR / ES
As business days go by, the CCP’s market data time series get updated. The large movement in the market will not only increase volatility but will potentially also be one of the scenarios above the VaR or ES quantile and increase the risk measure further. That level is visible in Figure 1 where there is a kink in the curve around -50bps, but this effect has not yet impacted the IM.
4. Variation margin
Due to the market movement, the VM will be large. For a mainly payer swap portfolio the VM will be a payment to the CCP, cash in GBP. This is extra collateral (if not received from a hedge position covered by a cash CSA) that will need to be sourced and posted in addition to IM (which is a longer-term requirement).