Everyone can agree that collateralisation is, in general, a good thing.
New rules on the margining of non-cleared over-the-counter derivatives trades, which started to be implemented in phases from September 1 last year, require market participants to post both initial and variation margin on covered trades, applying specific requirements laid out by regulators.
While this should slash exposures within the largely bespoke, bilateral derivatives market, industry participants are increasingly starting to worry about a risk that has largely been ignored because of other priorities – the risk of settlement.
One might assume the increased use of margin would eliminate the problem of settlement risk – or Herstatt risk – that arises when one party to a transaction pays up and the second then fails to do so.
But that isn’t necessarily the case in practice.
In this month’s first technical article, Does initial margin eliminate counterparty risk?, Leif Andersen, the global co-head of the quantitative strategies group at Bank of America Merrill Lynch, Michael Pykhtin, a manager in the quantitative risk team at the Federal Reserve Board in Washington, DC and Alexander Sokol, the head of quant research at risk technology vendor CompatibL, show the presence of initial and variation margin reduces exposure by less than a factor of 10, as opposed to a factor of 100, which regulators were expecting.
The numbers might appear shocking, but do not come as a surprise to everyone. And there are good reasons for that.
For starters, banks are still implementing the rules, notes a managing director at a large US bank: “The margin rules have been going on for 10 years and it’s been completely all-consuming… We actually attempted to try to get something done. Eventually people just didn’t have the stamina to be able to do that.”
According to the quants, the main source of margin settlement risk lies in the way margin payments typically work in the OTC market as dictated by the terms of existing collateral agreements – known as credit support annexes (CSAs).
Consider a swap – two types of payments occur between counterparties as part of the CSA and the accompanying trade documentation – the master agreement. The first of these is the interest payment on the swap – or the trade payment – and the second is the reciprocal margin payment.
Typically, the market data and trade data as at end of day T is used to value the amount of collateral to be posted the next day, or T+1. Once this has been instructed, the bank would typically receive the margin on T+2. This means there is always a gap between the trade payments and the margin payments. Missed margin payments or disputes do not immediately trigger punitive action for obvious practical reasons – these events could extend this period even further.
The real trouble is when there is a large trade payment during the margin period of risk (MPoR), or the period between last collateral exchange and the settling of the trade with the defaulting counterparty. During that time, the party that has made a trade payment runs the risk of not getting its cash back if the counterparty defaults – this translates into large periodic spikes in the swap counterparty exposure. Dealers say this ‘spike effect’ is well-known.
In their paper, the quants propose a two-part solution to this problem – first is to tweak CSAs so trade payments and reciprocal margin payments
fall on the same day. This would eliminate the time lag between the two types of payments.
Market participants say some banks already have this arrangement on a handful of trades where the client has agreed to it – in some cases, the aligning of the cashflows was preferred by the client.
What would reduce the risk further is settling the above through CLS Bank, which uses a payment-versus-payment (PvP) system for foreign exchange settlement – that is, one party gets paid only when the other pays.
This seems a far more complex undertaking, but was in fact considered for currency settlement during industry discussions that began in 2011 to develop a standard CSA.
At the time, some even considered extending this to swap cashflows. “One of the ambitions we always talked about in those groups was why not also extend the PvP mechanism to include swap cashflows? Because what is the difference between a swap cashflow and a margin payment? Really nothing, physically” says the managing director at the first US bank.
What is surprising here is just how many market participants already have a view on an issue that was only recently flagged up in a publicly available research paper – which indicates the significance of the risk.
Regulators are starting to pay attention too. The European Central Bank seems to have taken the first steps towards addressing this risk by including a section on the treatment of margin and trade payments within the MPoR as part of its Targeted review of internal models guidance, launched in 2015. What dealers need to do now is to turn what seems like a decade-long discussion into a solution that works in practice. The largest banks have almost sorted out their implementation of the margin rules, there should be no more excuses.