June 24 meant different things to different people: for those hoping the UK would cut its ties with the European Union, their shock victory ushered in a joyful 'independence day'; for politicians, it was a popular uprising; for sterling traders it was a day of historic volatility. And for swaps clearing houses and their members, it was an edge-of-the-seat, real-world stress test.
Estimates of the combined margin call issued by derivatives central counterparties (CCPs) on the day range from $25 billion to $40 billion or more, with their largest members each reckoned to have stumped up multiple billions. Those calls were met without any mishaps. But, four months on, the episode still arouses fear – at the concentrated liquidity risks it revealed; and anger – at the margining practices of LCH, which are now being closely scrutinised.
"Anyone who looks at this without concern is being cavalier," says the US-based head of one bank's clearing business. "Every clearer made its payment, there were no credit events, but I believe the regulators need to look at the total level of payments that were made and ask themselves whether they are comfortable with a system in which a handful of clearing members is being asked to fund tens of billions during volatile conditions."
A US-based expert on cleared derivatives markets calls it "a warning shot across the bows of the regulators" and says officials need to "contemplate the consequences, now becoming evident, of the policy moves they have made".
So, what were those consequences, and how did the Brexit vote reveal them?
Brexit, pursued by a bear
Events were set in train on June 24 in the small hours of the morning, UK time, when results from around the country showed Remain had won by a smaller margin than expected in some locations, while Leave had sprung a surprise in others. The shock result was clear by around 4am, setting the scene for a violent day of trading.
According to analysis conducted by UBS for this article, a number of assets saw record-breaking moves during the day (see figure 1): sterling posted its biggest intra-day trading range in more than 20 years against both the US dollar and the euro, while euro/US dollar recorded its second-biggest intra-day range in 10 years. The FTSE 100 and EuroStoxx 50 saw their biggest intra-day moves in five years, as did yields of 10-year UK government bonds.
These moves were not fully reflected in variation margin payments on June 24, which covered the prior day; so CCPs relied on planned or ad hoc initial margin calls to maintain levels of cover. The calls were made according to different methodologies and at different times – LCH, for example, makes three of these top-up calls every day, in all conditions, while Singapore's SGX makes four. Others, such as Eurex and CME, make their calls in a less rigid fashion (see box, The Eurex way). The combined impact was severe, according to the US-based clearing head.
"When the vote reversed, the markets also reversed dramatically. Starting at around midnight in London you saw US Treasury rates rallying by 32 basis points, which caused a big mark-to-market margin call. The first call from LCH was early in the morning, UK time. The call was for well over $1 billion. At the same time, we had CME making its call and then Eurex, and then there was another LCH call a couple of hours later," he says.
"When you have a call of that magnitude, you need approval from the highest levels in the bank. I will tell you, having been in this situation, that suddenly having to make a 10-digit payment makes people uncomfortable. To have to go upstairs and say, 'Excuse me, Mr Dimon, Mr Blankfein, could I please have $2 billion to meet a margin call for our futures and swaps clearing business,' that's awkward to say the least," the clearing head continues.
In all, he estimates the combined variation and initial margin calls on the day added up to as much as $40 billion for the biggest banks – a figure that three other clearing sources say is plausible, and which appears roughly in line with the fragmentary facts. A clearing head at a second bank puts it at a lower $20–25 billion (see box, Facts and guesses: how big were the margin calls?).
People had known the vote was coming and had taken precautionary measures. Well, what would have happened in a surprise event? How would the industry have handled that?
Craig Pirrong, University of Houston
Some sources claim to have heard that payments were not immediately authorised; but, whether that is true or not, the calls were ultimately met, and some might argue the story ends here.
Others take it a few steps further. What June 24 reveals is the sheer size of the intra-day funding requirements faced by futures commission merchants (FCMs), they argue, and the potential fragility of a system that relies on these firms being able to meet multi-billion-dollar calls in the space of 60 minutes. If those calls are not met, an FCM risks being declared in default, and having its positions liquidated.
The size of the calls was so large because of two factors: the violence of the market moves, and the increased size of the portfolios on which they were acting. Regulation is pushing more over-the-counter derivatives into CCPs, and these trades – being bigger and less liquid than their listed cousins – consume more margin. Taking regulatory disclosures from LCH as an illustration of the market's growth, total initial margin for the CCP's interest rate swap portfolio jumped 48% during the first half of this year, from £48.5 billion to £71.9 billion ($59 billion–$87.6 billion). As the cleared portfolio grows, so do the potential liabilities of a CCP's members during periods of stress.
Date in the diary
This liquidity risk is concentrated in a handful of FCMs. Nearly three-quarters of all US swaps clearing was being channelled through just five firms, as of March 2015: Credit Suisse, Morgan Stanley, Barclays, Citi and JP Morgan.
For these firms – and their fellow FCMs – Brexit should have been a non-event from a liquidity point of view, because it had been in the calendars of traders and risk managers for months. But markets are not always so kind, notes Craig Pirrong, professor of finance at the University of Houston: "People had known the vote was coming and had taken precautionary measures. Well, what would have happened in a surprise event? How would the industry have handled that?"
One certainty in such an event is that banks would need a tried-and-tested response.
"Using CCPs to manage this risk means you go into a world where margin payments are not negotiable – they have to be made, and they have to be made in a timely manner," says the US-based clearing expert. "If a bank does not meet the call within an hour, it is in default and its positions will be liquidated. So what June 24 suggests is that, at a minimum, we need to make sure the liquidity risk is understood and provided for better."
International banking regulations already include a requirement that banks carry enough liquid assets to meet outflows during a 30-day period of extreme stress – the liquidity coverage ratio. No provision is made for a 60-minute period of extreme stress, however.
"I worry we have fundamentally misdiagnosed the problem," the clearing expert adds.
The event has not escaped the attention of regulators. Speaking to Risk.net at an industry event in Chicago on October 19, Timothy Massad, chairman of the Commodity Futures Trading Commission (CFTC), said: "Obviously Brexit was a very volatile day and margins were increased as they should be in a situation like that. There is a concern that you don't want to be calling for a lot of margin in particularly volatile times if you can avoid that by having adequate margins in the first place... I would say that our clearing houses have pretty robust methodologies, [but] there is always room for improvement and we will always be engaging in that oversight."
Other regulators declined to comment, but pointed to a provision in Europe's clearing rules, which requires CCPs to take into account "any potentially pro-cyclical effects" of intra-day initial margin calls. International standard-setters are now working on more granular guidance on the topic, but regulators are not all on the same page - at a CFTC meeting on October 6, one of the agency's officials pointed out that variation margin constitutes a far larger proportion of daily funding needs and is also more sensitive to market moves.
Banks and buy-side firms have long warned that mandatory swaps clearing could generate intense intra-day funding stress.
In February 2012, the International Swaps and Derivatives Association submitted a letter to the Committee on Payments and Market Infrastructures (CPMI) and the International Organization of Securities Commissions (Iosco) highlighting the potential liquidity risk posed by intra-day margin calls.
"In relation to intra-day margin, in general CCPs do not provide physical payment for accounts with net mark-to-market gains. This produces a liquidity drain at the clearing member, which is significantly exacerbated by the fact that, unlike listed derivatives, clearable OTC derivatives are fungible products that can be cleared at more than one CCP. In the absence of refined standards for intra-day margin practices, clearing members are exposed to a serious liquidity risk as they risk-intermediate CCPs in distressed market conditions," the letter reads.
Fresh warnings were voiced just days before Brexit. At a board meeting of the Futures Industry Association (FIA) held in early June, a number of FCMs are said to have voiced concerns about the stress that would result from multiple intra-day calls in the midst of a crisis.
"That issue was raised at an FIA board meeting in the first quarter. It came up again at the London board meeting held in June and a number of FCMs revealed they had concerns about these intra-day calls. The point the FCMs made was that if we have a 25-basis point move, this is going to suck a tremendous amount of liquidity out of the market. That meeting took place about two weeks before Brexit," says one attendee.
In the event, that kind of move was exactly what the market saw. Yields on 10-year US Treasuries tumbled 29bp, from a high of 1.70%. In 10-year gilts, the intra-day move was less dramatic, but after a further day of trading, yields had dropped from a June 23 high of 1.39% to just 1.01%. By June 30, yields had slumped further to just 0.86%.
It's not clear how big a call the banks could comfortably fund, but the treasurer at one French bank believes the industry has the capacity to deal with a bigger event than Brexit.
"Intra-day, there is a lot of money floating around in the system. It's not like a margin call even as large as $60 billion – if split among a dozen banks – would be hugely problematic, because they are probably sitting on fairly large balances overnight. That is either being regarded as working capital or as a balance that will be left at the Federal Reserve or the European Central Bank overnight," he says.
So, are the banks crying wolf?
Paul Glasserman, professor of business at Columbia University Business School, argues the liquidity risks of derivatives clearing need to be managed more carefully. That means giving more information to the banks, he says.
"Everybody wants margin to reflect risk, but the more risk-sensitive you make margin levels, the more they spike when markets become volatile. The Brexit experience may be a useful reminder of how this plays out. There's no question that the increased use of collateral reduces counterparty risk at the expense of increased liquidity risk. I think the key is for banks to have enough information about potential margin calls to be able to stress-test their liquidity needs when volatility spikes – including planning for intra-day margin calls from CCPs in volatile markets, which shouldn't come as a surprise," says Glasserman.
A senior executive at one Asian CCP says this cuts both ways: clearing houses would also like more information on the emergency funding capacity of their members.
"We have very little visibility at the moment. We've always wanted more, but the banks just tell us we're a small part of their overall funding needs," he says.
That may be true. But it's probably also true that cleared portfolios will continue to grow – with an uncertain impact on the net amount of cleared risk – and that future market moves could be more sustained and violent than those seen on June 24. The collapse of Lehman Brothers, for example, saw 10-year US Treasury yields suffer 33bp and 47bp intra-day moves on successive days.
For Anat Admati, professor of finance and economics at Stanford Graduate School of Business, navigating this kind of event comes down to better understanding of network effects and – possibly – early intervention.
"To prevent systemic stresses, we must understand the interconnections in the system and aim to intervene promptly. The problem of simultaneous margin calls from clearing houses illustrates that mandating central clearing by itself is unlikely to reduce the fragility of the financial system unless CCPs and their main members are less opaque and more effectively regulated than they are," she says.
The Eurex way
German derivatives exchange and clearing group, Eurex, takes a hybrid approach to intra-day margining, making variation and initial margin (VM and IM) calls on a regular basis, but not according to a fixed timetable.
"At Eurex we call both intra-day VM and intra-day IM and there is no scheduled timing for these margin calls: they are event driven. We calculate risk in real time, so every price update, every position update will trigger a revaluation of the position and revaluation of IM and VM. If a member breaches a threshold – 10% of its overnight margin requirement – then we will call for margin," says Thomas Laux, chief risk officer at Eurex in Frankfurt.
"There are two drivers behind these calls: if there is big market move – such as Brexit – it will mainly be VM that we call. Alternatively, if members are taking a lot of new positions during the day, then it is mainly IM that we call. On average we make 10 to 15 calls every day for different reasons, but that is across 200 clearing members. That could be for VM or IM, but it is only a small subset of our members that we call," he says.
Laux acknowledges Brexit was a major stress event for Eurex, but notes the stress was only distributed across half of the Eurex clearing membership, since under its margin methodology cash from members with losing positions is transferred to members with winning positions, meaning the amount of liquidity within the system remained constant.
When it comes to the margin funding practices of banks, Laux says clearing members tend to fall into two groups. The first tends to leave excess margin at the central counterparty (CCP), in some cases as much as 20% of the value of collateral held against live positions. During Brexit, this group was not called intra-day since the excess collateral was sufficient to absorb the market volatility.
Facts and guesses: how big were the margin calls?
Pinning down a precise sum for the June 24 margin calls is tricky, but some of the components are known.
CME Clearing confirmed to Risk.net the size of its calls on June 24 – a Friday – and June 27, the second day of trading after the Brexit result. On the first day, the CCP called for approximately $14 billion of variation margin (VM) from losing clearing members, which was transferred to those with net winning positions on the same day. This compares to an average daily VM call of $3–4 billion, the CCP says.
Intra-day IM calls on June 24 were "negligible" according to CME Clearing, but it did call for $2 billion in supplemental IM from members on June 27, and made a further $8 billion VM call the same day.
The size of the June 24 calls from Eurex are not known, but the biggest IM and VM calls made by the clearing house during the second quarter are a matter of public record – they are reported in line with international standards set by the Committee on Payment and Market Infrastructures (CPMI) and the International Organization of Securities Commissions (Iosco). No date is given, but the largest single-day amounts collected by Eurex during the period were €7.8 billion ($8.5 billion) and €18.9 billion.
In the case of CME and Eurex, the margin numbers apply to both over-the-counter and listed derivatives. LCH's corresponding CPMI-Iosco disclosures are broken out by business line, showing a £5.2 billion single-day IM call and £11.9 billion VM call for its interest rate swap clearing business in the second quarter.
Banks have long complained that LCH's margin practices are too conservative. The clearing house makes three IM top-up calls each day. These calls – termed "market data refreshes" by the CCP, and made on a gross basis – are accompanied by an end-of-day net VM call that clearing members are obliged to meet the following morning.
Clearing members claim they effectively have to collateralise the same market move twice – once in the form of the gross intra-day calls on the day of the move itself, and again the following morning in the form of the netted VM call.
Following industry complaints about the size of the LCH calls on June 24 and 27, the Futures Industry Association (FIA) established a working group to liaise with the clearing house on making revisions to its practices. LCH has committed to make changes including allowing clearing members to use unallocated excess cash sitting at the CCP to be used in meeting intra-day calls from November 3.
"We have been working very co-operatively with LCH in order to resolve these issues. The way the system currently works is that you're collecting for the same risk twice and as a result it is pulling valuable liquidity out of the market at a time when it may need it," says FIA chairman Walt Lukken.
"When markets are stable for a long period of time, what that does for these risk models is that it tends to lower margin. The jump in margin is the correct action, but it probably indicates that the original amount of margin is too low. We are trying to solve for that so that you don't have those big margin calls all at the same time," Lukken adds.
The second group prefers to manage margin calls as and when they come. For these firms, such events normally entail a trip to the bank's treasury unit to request additional funds. In most cases, clearing members have just one hour to remit the requested funds back to the CCP.
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