Academic journal article Economic Perspectives

Cleared Margin Setting at Selected CCPs

Academic journal article Economic Perspectives

Cleared Margin Setting at Selected CCPs

Article excerpt

Introduction and summary

Since the financial crisis of 2008-09, considerable attention has been given to the financial resources required to guarantee performance of various counterparties in financial transactions or contracts. Direct bilateral counterparties to dealer-to-dealer and dealer-to-end-user transactions are now required to exchange collateral as performance bonds, also known as margin. Clearing members of central counterparties (CCPs) are similarly subject to minimum margin requirements as set by the CCP. End-user clients face margin requirements set by their clearing member agents that are equal to or higher than the CCP minimum.

Regulatory reforms since the financial crisis have mandated the use of CCPs for the clearing of over-thecounter (OTC) derivatives when possible (based on their degree of standardization, among other factors). This mandate, plus the increased use of listed derivatives generally, has resulted in additional scrutiny being given to the margin-setting methodologies used by CCPs.

The purpose of this study is to examine the regulations, principles, rules, policies, procedures, and best practices that cover the setting of derivatives margin by CCPs.' Source materials for this study include publicly available documents and data, such as the rules of the CCPs and publicly disclosed margin material. We have conducted extensive interviews with senior CCP personnel who have responsibility for margin policies and their implementation. In all, we interviewed people at six of the world's largest and most diversified CCPs. We gratefully acknowledge their cooperation, as well as input and comments from staff members of the Federal Reserve Bank of Chicago's Financial Markets Group. In addition, we reviewed national regulations and international standards and principles as they apply to the adequacy of the financial resources of CCPs generally and margin levels specifically.

The financial resources available to CCPs vary by regulation and by the CCP's commercial structure. Some CCPs are organized for profit with fiduciary responsibility to their shareholders (who may or may not be clearing members), while other CCPs operate as at-cost utilities.

Regardless of their corporate structure, all CCPs rely on their "risk waterfall" of financial resources to cover a financial deficit (that is, the insufficiency of financial resources available to cover a CCP's obligation to clearing members, caused by the default of one or more of its clearing members). A CCP will use the financial resources in the order of application as defined by its rules. Typically, the first level of claim by a CCP is the margin and default fund contribution of the defaulting clearing member, followed by resources including a portion of the CCP's capital, the remainder of the default fund, assessments applied to the surviving clearing members, and additional CCP resources, if necessary. (2) The priority of the defaulter's margin in the waterfall makes clear the different roles of margin and the default fund (also known as a guaranty fund). The default fund is separate from margin, contributed by clearing members (in a pro rata amount) and, importantly, is mutualized--a draw-down of default fund resources will affect all nondefaulting clearing members. It is therefore of concern that the initial margin be set correctly in order to minimize the need to utilize the remaining layers of the waterfall.

The balance between margin levels and default fund contributions is important because less of one implies the need for more of the other. A larger default fund might allow for lower margin requirements, but at the cost of making the use of mutualized resources more likely. Clearing members expect the CCP, acting on their behalf, to set margins at levels high enough to cover CCP settlement risks without drawing on the default fund. Because all clearing members make contributions to the default fund, they are sensitive to the free-riding and moral hazard implications of possibly relying too much on mutualized resources. …

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