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Office of Financial Research Academics Examine "Procyclical" Central Counterparty Margin Requirements

Steven.Lofchie@cwt.com's picture
Commentary by Steven Lofchie

Office of Financial Research academics analyzed the effects of "procyclical" central counterparty ("CCP") margin requirements.

In a working paper, professor Paul Glasserman and Qi Wu of the Chinese University of Hong Kong addressed the consequences of the imposition of margin requirements that are "risk-sensitive" and could result in increased margin requirements at times when market participants may find it the most difficult to raise the necessary assets to post as collateral. The primary question posed in the paper is how much higher margin requirements should be in order to avoid the procyclical results dictated by risk-based margin requirements.

The authors apply an analytical framework to standards adopted in the European Union to avoid procyclicality in CCP margin requirements (which standards effectively are binding on U.S. clearinghouses that wish to qualify for "recognition" under EU rules). The authors criticize these standards for being "vague" and for failing to recognize differences between asset classes, and suggest ways in which more highly tailored mathematical analyses could lead to standards that better address the concerns of procyclicality.

Commentary

If government regulators have set margin requirements that effectively are procyclical (which likely is the case), then a good argument can be made that central clearing exacerbates systemic risk. That is, in the event of significant market downturns, clearing corporations exercise their unilateral power to demand more margin, which will suck liquidity out of the markets and accelerate a downward spiral. That is why the supposed obvious advantages of a central clearing system may not be so obvious when compared to a system in which margin requirements are negotiated and set based on bilateral terms through decentralized and diverse decision-making.

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