Journal of Financial Market Infrastructures

Risk.net

Choice of margin period of risk and netting for computing margins in central counterparty clearinghouses: a Monte Carlo investigation

Jayanth R. Varma and Vineet Virmani

  • Net margins with double the Margin Period of Risk are less safe than gross margins.
  • Net margins perform poorly when client positions are highly heterogeneous.
  • Crowded trades also create problems for net margins.
  • Monte Carlo simulation with Student’s t copulas is a tractable tool for studying risks and associated trade-offs in clearing.

Given the increasing importance of central counterparty clearinghouses (CCPs) to developments in modern financial market infrastructure, in this study we provide a quantitative comparison for evaluating the impact of collecting margins in a grossversus- net system with the margin period of risk (MPOR) set to between one and five days. Historically, gross and net margins have been used by different CCPs, and the two-day MPOR has been used to compensate for the leniency of the net margining system. Using a Monte Carlo experiment design, we analyze the trade-off between gross and net margins in scenarios where a large client of a clearing member defaults idiosyncratically and where defaults arise out of “crowded trades”. We describe the conditions under which the longer MPOR does, or does not, offset the risks induced by net margins. We find that the level of client heterogeneity plays a crucial role in determining the trade-off. Our modeling framework encapsulates the complex multilevel margining system in a few parameters that CCPs and their supervisors can easily calibrate based on data privately available to them. Our simulation methodology could thus be useful for CCPs to analyze the effect of other changes to the margining system.

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