Historically CCPs were able to set their own standards for risk management, collecting sufficient margin to cover the market risk under normal market conditions, with the fallback of the default fund to cover losses under stress scenarios.
This all changed after the 2008 financial crisis. The transfer of bilateral OTC exposures to CCPs became a key regulatory objective resulting in a whole new set of regulation, including the Principles for Financial Markets Infrastructures. This added specific risks that CCPs needed to consider in their risk management as they were required to add new components to the existing margin algorithms. This resulted in the relationship between positions and margins no longer being linear.
The new risks
The margin calculated by a CCP must now – in addition to the market risk – also cover liquidity risk, default risk and credit risk. And, at the same time, they have to make sure their margin isn’t procyclical – CCPs increasing margins in a time of stress making the situation worse.
The inclusion of these extra risks has led, as would be expected, to an increase in margin.
However, there have been some unexpected consequences resulting from the way CCPs have decided to cover these risks. The changes have resulted in significant additional complexity in achieving an efficient approach to allocating business. In other words, the simple rules of thumb no longer achieve an efficient outcome.
Historically clearing allocation decisions were back-office-led, defined by operational ease/clearing technology solutions. Smart firms are starting to embrace the fact intelligent allocation of clearing business is now a bottom line contributor and, increasingly, a commercial differentiator within their peer group. An understanding of the way in which the new algorithms work is required in order to minimise the overall margin, and hence maximise the capital efficiency.
The new liquidity add-ons mean the margin is no longer proportional to the size of the position. In some extreme cases this additional charge can be up to 70% of the margin. But by the correct placement of positions between clearing brokers it is possible to minimise this charge and gain up to a 40% saving in overall margin.
CCPs use stress testing (calculating loss over margin under various stress scenarios) to determine the size of their default fund. Regulation states that the size of the default fund must always be sufficient to cover the largest 2 losses, and that if it isn’t it must be made good at the earliest possible opportunity. To achieve this, the CCPs have introduced ‘Default Additional Margin’.
The calculation of Default Additional Margin is generally based of the size of members’ stress testing losses, being charged only on those members’ whose loss is significant. An example calculation of Default Additional Margin would be:
“Where a clearing member’s stress testing losses are more than 45% of the default fund size an additional margin will be required to reduce them to 45%”.
But why does this impact capital efficiency?
Well, if the clearing broker you are using happens to be big then they may be subject to Default Additional Margin. And if that happens they may just pass a share on to you.
Additional Margin may be requested by a CCP if they believe a clearing member’s credit score has fallen below the expected level. There is no particular way this would be calculated, but it would generally be additional cover for market risk, for example a percentage of the initial margin or stress loss.
Again, this could result in increased margin if the clearing broker you are using is being made to pay Credit Additional Margin and decides to pass it on.
So what’s the effect and what can you do to minimise the impact?
1. Liquidity risk
At a simplistic level, the best way to avoid the impact of liquidity add-on is to increase the number of brokers used. As the margin is a non-linear calculation, dependent on the size of position, the more you can split the portfolio between clearing brokers the lower the liquidity add-on will be – with savings of as much as 40%.
However, too much diversification can reduce base portfolio offsets. It is therefore necessary to find the optimum allocation of positions between brokers, achieving the right balance between add-on margin reduction and ensuring base offsets aren’t adversely impacted.
This is a problem best solved using an automated solution. This would need to be one that fully understands the complexity of CCP margin algorithms, and that has the ability to factor in customer specific operational constraints and provide daily recommendations to port trades and positions between brokers to reduce margin.
2. Default and credit risk
Default and credit add-ons are only going to impact you if (a) your clearing broker is subject to them and (b) they decide to pass the cost on to you. But if both of those are true, how big can the impact be?
Let’s assume that the size of a given default fund is $1 billon. The clearing member with the largest stress loss over margin this loss is 55%, and the way that the default add-on is as described above, then the member will have to fund an additional $50 million (the difference between 45% and 55% of the size of the fund).
The size of the credit add-on will be dependent on how low the credit rating of the clearing member has fallen. In a worst case scenario this could be 100% of the calculated margin.
As these add-ons are at the clearing member level, they cannot be directly controlled. However, by using an automated solution that provides daily tracking of broker margin versus independent validation, it is possible to monitor whether a clearing broker is passing these costs on.
To sum up:
- New regulation introduced following the 2008 financial crisis has resulted in a host of margin related changes. Margin add-ons, in particular, are little known and commonly misunderstood.
- These new components to the existing margin algorithms have crucially resulted in a much less predictable relationship between the position held and the level of margin required.
- Without careful management of the way positions are allocated to clearing brokers, the resultant increase in margin can have a significantly negative impact on capital efficiency and therefore erode bottom line returns.
- However, by efficiently allocating trades to CCPs and clearing brokers on a pre- and post-trade basis, margins can be significantly reduced.