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Initial Margin: Theory and Practice

The news that the CME CCP will be accepting corporate bonds and that LCH-Clearnet will accept RMBS for initial margin has me thinking about the dangers of demutualisation of clearing houses.  Managements of shareholder owned clearing houses are keen to compete for market share and volume to increase revenues, bonuses and profits (not necessarily in that order).  The interests of their members (and of central banks and taxpayers who may be asked for bailouts) may require more prudence than managements might prefer.

No where is the tension more obvious than in the scope of assets accepted for initial margin.  It is worth remembering that clearing houses only take very short term risk.  One day risk is normal for exchange traded derivatives.  A default will be determined, positions liquidated and final settlement of initial and variation margin made on the same day.  Several days to several weeks risk might be more sensible for OTC derivatives which are less liquid and more difficult to price quickly among a small cadre of dealing firms.

The initial margin the clearing house takes from each member is intended to cover the liquidation costs to the clearing house of disposing of the member's open positions at the time of a default.  As markets come under stress when members default, and members default when markets come under stress, it is quite likely that the clearing house will be closing out positions and liquidating initial margin assets into stressed markets.  The assets taken as initial margin should be of a quality that they are cash equivalent - traded in liquid markets where they can be disposed of for cash as and when the clearing house needs it.

For that reason it has been best practice for clearing houses to only take cash and very liquid government securities as initial margin.  Cash and government securities tend to be counter-cyclical assets in stressed markets, gaining value from their superior credit quality, liquidity and price transparency.  Corporate bonds and RMBS may be valuable assets, but we have seen that prices collapse and market liquidity evaporates under stress conditions.  They are pro-cyclical assets, and the very act of CCP liquidation will further stress already stressed markets against the CCP realising the value it might have projected before the default.

I'm sure that the risk committees at the CCPs are aware of all this, and that there are prudential limits and generous haircuts on the use of either corporate bonds or RMBS as initial margin in their rules.  It still makes me nervous that pro-cyclical assets will be eligible as initial margin.  Rules will tend to be relaxed and exceptions become more normative as markets become complacent and competition intensifies.

The IMF is projecting a huge shortfall in quality, liquid assets driven by record balance sheet encumbrance of banks forced to secured lending markets, immobilisation of collateral assets in margin and CCPs, and downgrading of assets which were once thought quality but now are looking worse and worse.  If clearing houses begin to compete on the scope of accepted initial margin, that will increase the risks already concentrated in the CCPs.

Members who must backstop the capital and default guarantee fund of each clearing house should be paying attention.  So should the central banks that will have to backstop liquidity for a CCP.  And so should treasuries - and behind them taxpayers - who may end up having to recapitalise or bailout a troubled CCP.

There was a reason that market infrastructure was run on mutual principles of membership for most of the last three hundred years.  It concentrated minds on risk management for the longer term - over the business cycle rather than the bonus cycle.


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