United States: FIA Considers Effects Of CCP Demands For More Margin During Pandemic

In a new white paper on the performance of the central counterparties ("CCPs") during periods of extreme volatility, FIA concluded that the CCPs performed sufficiently and were resilient. FIA determined that the CCPs' successful performance was due in significant part to the required posting of high levels of margin. However, FIA found that the clearinghouses' demands for increased margin put extreme pressures on liquidity in the rest of the financial system.

FIA determined that the derivatives market continued to perform well through the financial crisis, as trades settled and markets remained open and fully-functioning throughout.

FIA also concluded that demands for initial margin by the clearinghouses - which FIA described as an "extreme shock" resulting in an increase of $270 billion in margin requirements - put "extreme pressure on the availability of cash and other high-quality liquid assets." This increase in margin requirements contributed to a "dash for cash" that "caused extreme dislocations in the US Treasury markets." FIA credited the Federal Reserve's provision of emergency market support for limiting the severity of the liquidity problem, but also noted that "relying on emergency actions by central banks is not a good foundation for managing liquidity risk."

Among other improvements, FIA recommended the following changes to the clearing system:

• strengthening the setting of margin floors to control the procyclicality of margin requirements, implying that some clearinghouses have set floors too low;
• measuring the potential for sudden increases in initial margin, and using such measurements to appropriately calibrate a cap on the maximum rate of increase for initial margin requirements over a set period of time; and
• revisiting the procedures for intraday margin calls.

Commentary Steven Lofchie

It was predictable that the ability of the CCPs to demand, without much notice, an unlimited additional amount of initial margin would (i) enable the CCPs to save themselves at the expense of other market participants and (ii) drain liquidity from the market during a period of market stress, thereby significantly worsening market stress. See, e.g., Streetwise Professor Warns That CCP Mandates Are Creating Liquidity Risk and Systemic Stress; Professor Craig Pirrong Comments on the Prospect of Nationalizing Clearinghouses; Lofchie Comment as to CFTC Chair Timothy Massad Considers Central Clearing in an Evolving Market.

This does not mean that one should abandon central clearing of standardized products; that is not politically or economically realistic. But it ought to be obvious that allowing one type of massive counterparty to demand unlimited high-quality margin from others is going to cause a dangerous liquidity squeeze (that requires central bank intervention) in a financial crisis. Fixing this problem is likely to require those who over-touted the solution to consider its limitations.