Courtesy of Mete Feridun
Disclaimer: The views and opinions expressed in this blog are those of the author and do not necessarily reflect the official views and opinions of PwC.
Post-crisis regulatory reforms have resulted in the majority of derivatives being cleared through central counterparties (CCPs) or subject to bilateral collateral requirements, such as the exchange of variation margins, the requirement for counterparties to post initial margins, and the application of collateral haircuts. In particular, the minimum haircut framework for non-centrally cleared securities financing transactions (SFTs) designed by the Financial Stability Board (FSB) reduced risks associated with under-collateralization of market participants, while the exchange of variation margin has made the financial system safer by preventing the build-up of excessive uncollateralized exposures. The move to CCPs has also been a cornerstone of the post-crisis reforms by reducing risks in derivative transactions.
However, by channeling liquidity through the financial system, margin and haircut practices may still lead to risk build-up by amplifying procyclical macroeconomic developments. More specifically, procyclicality associated with margin and haircut practices may lead to an enhanced risk of contagion in the event of default, while variation margin and/or initial margin calls can put even more severe and concurrent liquidity stress on market participants. Another related risk is the impairment of SFTs. This could cause substantial strain on counterparties that are unable to convert collateral into cash during times of severe liquidity stress. So, increases in haircuts and/or changes in collateral eligibility can create a vicious cycle of severe liquidity stress in the financial system and threaten financial stability.
Although not responsible for developing detailed regulatory standards, the European Systemic Risk Board (ESRB) in the European Union published a report in 2017, introducing a number of potential macroprudential tools to address these risks. In particular, it identified potential options to constrain the buildup of leverage during booms and to reduce liquidity strains during times of market stress. While this report was insightful, it fell short of addressing all related risks. Therefore, the ESRB continued to undertake data analysis and collect market intelligence on the functioning of the derivatives and SFT markets after publication. Based on these analyses, the ESRB published a new report on 9 January 2020, setting out a number of policy options designed to limit the cyclicality of margins and haircuts in derivatives transactions, as well as to increase the resilience of SFT market participants.
It appears from the new report that the ESRB is now placing greater emphasis on tools designed to reduce liquidity strains during times of market stress than on those that constrain the build-up of leverage during booms. It introduces policy options to reduce liquidity strains from margins and haircuts during times of stress. These are thought to reduce the cyclicality of initial margins and to contribute to reducing the build-up of leverage during booms.
The ESRB appears to be particularly sensitive about not introducing any policy options that may restrict the use of variation margin or discourage the central clearing of derivatives transactions. Taking into account that variation margin calls can put severe liquidity stress on market participants, the ESRB aims to mitigate the impact of variation margin calls on the liquidity of market participants but it does not restrict the use of variation margin. The ESRB also emphasizes the importance that the policy options designed to mitigate procyclicality do not lead to under-collateralization of market participants, particularly for CCPs. It is also noteworthy that the ESRB considers the move to central clearing as one of the cornerstones of the post-crisis regulatory reforms and advises that it should not be undermined. Hence, its policy options introduce enhanced incentives to use central clearing.
Given that some of the options identified might entail increased operational complexities and costs for market participants, with some important potential implications for the competitiveness of the EU financial system, it is important that the ESRB carries out further analysis of these policy options. This analysis should use new data sources where possible. Further, the analysis should review the policy options for the potential side effects they may have on the relevant markets and how they could be incorporated into regulatory frameworks.
In particular, it is important that the ESRB carries out a further assessment of the interaction between the options and existing regulations, such as the anti-procyclicality regime set out under the European Market Infrastructure Regulation. The ESRB’s report provides a detailed discussion of these among its planned activities. But the ESRB should also engage with overseas regulators and the representatives from overseas derivatives markets. This would ensure consistency in cross-border regulations in different jurisdictions and avoid an unlevel playing field across global financial markets.