Journal of Financial Market Infrastructures

Central counterparties (CCPs) and the role they play in the efforts to strengthen the global financial system are subjects of intense discussion in the regulatory and market participant communities. Much of the focus of these discussions has been on tail risk in the context of the extreme events of CCP recovery or resolution. The issues involved with CCP resilience are of at least equal importance, however, and the single most important issue for CCP resilience is margin.

The six papers in this special issue of The Journal of Financial Market Infrastructures provide a range of insights into the topic of cleared margin. The contributions are from both the regulatory community and CCPs, and originate from Europe, the Americas and the Far East.

The issue’s first paper, “Cleared margin setting at selected central counterparties”, is intended to be introductory, with the goal of creating a common perspective on the topic of cleared margins, especially for those with a background in bilateral markets. Richard Heckinger, David Marshall and I examine the historical evolution of initial margin setting at CCPs and end with an inventory of the contemporary challenges and policy issues identified by a select group of major CCPs.

Initial margin estimations for credit default swap portfolios” by Stanislav Ivanov, the second paper in this issue, examines a new frontier in margin methodology using copula-based Monte Carlo simulations. Following a detailed discussion of initial margin components and various margin methodology approaches, Ivanov concludes that model risk associated with risk factor dependence modeling can be mitigated by incorporating risk measures from different correlation regimes into portfolio initial margin requirements, facilitated by the use of copula-based Monte Carlo simulations.

The next two papers examine the important issue of evaluating the efficacy of initial margin models. Max Wong and Patrick Ge take a new approach in “Performance testing of margin models using time series similarity”, our third paper, using a performance test to account for margin shortfall, procyclicality and efficiency, going on to compare this with an idealized regulatory target model. In our fourth paper, “Initial margin model sensitivity analysis and volatility estimation”, Melanie Houllier and David Murphy examine initial margin model sensitivity analysis by suggesting a new approach to parameter selection based on the statistical properties of the worst loss over a margin period of risk estimated by the margin model being tested. This can provide the valuable insight that a margin model may be highly accurate for a limited period of time but less robust in changing market conditions.

Moving beyond the critical realm of statistical validation of margin models, there is the issue of margin adequacy in a default with an actual liquidation of a defaulter’s position. Evangelos Benos, Pedro Gurrola-Perez and Michael Wood tackle this question in the issue’s fifth paper, “Managing market liquidity risk in central counterparties”, as they examine margin add-ons and the different approaches and challenges to integrating market liquidity risk with the margin model.

Finally, Sunil Cutinho, Suzanne Sprague and Matt Waldis discuss the relative merits of fully automated model-based margins and models that incorporate expert judgment in their forum paper “A balanced approach to central counterparty margining”. They conclude that the two methods are complementary, with each complementing the other’s shortcomings. They also observe that CCPs should be left with the flexibility to determine the proper balance between the two.

Taken as a whole, the papers in this special issue provide a reminder to us all that cleared margin setting, despite all of its quantitative sophistication, remains an art more than a science. Having started a discussion in The Journal of Financial Market Infrastructures with this issue, I hope this will encourage more submissions on this critical topic.

Robert T. Cox
Federal Reserve Bank of Chicago

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