Procyclicality in Sensitivity-Based Margin Requirements

Paul Glasserman and Qi Wu

15.1 INTRODUCTION

Margin requirements for derivatives reduce counterparty credit risk, but procyclical requirements can strain funding liquidity in times of market stress by increasing sharply with increased volatility. The industry standard model for initial margin in the non-cleared market, the Standard Initial Margin Model (SIMM), includes features to reduce procyclicality. Using the example of an option on an interest rate swap, we show that the method is nevertheless subject to procyclicality through the dependence of price sensitivities on market conditions. The degree of procyclicality varies across contract types and market conditions. Anticipating potential margin spikes requires regular liquidity stress testing and would benefit from greater transparency in the updating of model parameters.

Margin requirements for over-the-counter (OTC) derivatives support financial stability by reducing counterparty credit risk: margin provides a buffer that protects one party to a contract from losses upon the default of the other party. But margin requirements can potentially amplify liquidity risk: if margin levels spike in times of market stress, then market participants need