The central clearing mandate for OTC derivatives has forced CCPs to apply various combinations of SPAN and VaR margin calculation techniques to portfolios containing a mix of listed and OTC derivatives. The inherent unwieldiness of these approaches poses
a question – how much longer before every CCP applies VaR to all cleared derivatives, whether OTC or listed?
Central clearing upsets the apple cart
For over 25 years, the SPAN method has been used by futures and options exchanges to calculate margin requirements for portfolios consisting of listed derivatives. Meanwhile, the VaR margining system was used for OTC derivatives. There was no overlap in
the calculation of margins for listed and OTC derivatives, and margin optimization was pretty straightforward.
Before the financial crisis in 2008, most collateralized OTC derivative trades were conducted without any segregation of margin called. In the aftermath of the crisis, this practice was identified as a major reason why the ripple effects of the AIG collapse
could not be mitigated. To prevent a recurrence of such a situation, regulators mandated that OTC derivatives should be cleared centrally.
However, ever since clearing was introduced for OTC derivatives, trading portfolios have begun to consist of a mix of OTC and listed derivatives, forcing CCPs to use a combination of SPAN and VaR margining methods. There is no standardization in the approaches
adopted by CCPs, and the approaches taken by CME and ASX, for example, differ substantially from the approach taken by Eurex and NLX.
Little margin for error
With some estimates of the initial margin required under new regulatory proposals topping $10 trillion, it is understandable that margin optimization has become a topic of prime importance for CCPs and clearing brokers.
A CCP cannot afford to err too much in setting margin requirements. The consequences of a CCP’s margin requirements being too high are straightforward – it would increase operating costs for the CCP’s clearing members and their clients, forcing them to clear
their trades elsewhere. However, a CCP’s margin requirements cannot be too low, either – if a client were to default, not only would the loss wipe out the margin amount held, it would also hit other contributors by eating into the shared default fund.
Complexity cascading outwards
Unlike the Dodd Frank Act, EMIR provides for the continued use of omnibus accounts for clearing OTC derivatives, and requires clearing members to offer their clients a choice between individual and omnibus client segregation. When offered this choice, it
is probable that at least some buy side users will opt for the cheaper option and select omnibus client segregation.
To meet this demand from the buy side, clearing brokers will need to both mirror the margin calculations used by CCPs for each of their individually segregated clients and also calculate separate margins for each client in the omnibus account. As a result,
the complexity in a CCP’s margining technique will lead to even more complexity for the clearing brokers.
The end of SPAN?
Because of this recent increase in complexity, and its attendant costs, it is quite likely that the future will see the adoption of VaR across the board. After all, its far easier for clearing brokers to mirror the different flavours of VaR than to replicate
the current convoluted mix of SPAN and VaR.
The only thing holding back universal adoption of VaR is the difference between listed and OTC derivatives in the holding period used in margin calculations.
It is probably only a matter of time before the markets find a way around this issue and call time on the use of SPAN.