More should be done to ensure margin concentration add-ons are calculated appropriately by central counterparties (CCPs) – perhaps with the involvement of regulators – say market participants, following hefty losses at Nasdaq Clearing on a position that was not deemed concentrated enough to warrant a margin top-up.
In September, Nasdaq Clearing members were left mopping up losses of €107 million ($122.0 million) when spread trades put on by Norwegian power market trader Einar Aas blew up, wiping out two-thirds of its €166 million commodities default fund.
Nasdaq Clearing tells Risk.net it applies concentration add-ons if the size of the calculated margin requirement exceeds a certain threshold in initial margin for a particular product group. But in the case of Aas, the threshold was not exceeded at the time of the default and therefore the concentration add-on was not applied.
This has raised eyebrows among clearing experts. “How did the exchange let this guy have such concentrated positions? He pretty much had 50% of all open interest in the spread position,” says a former head of CCP due diligence at a major bank.
Concentration add-ons are applied to a counterparty’s initial margin payments to cover potential costs where the liquidation of a portfolio may be delayed because of the difficulty in offloading the highly concentrated positions within it. The charges included are also intended to cover custody fees for which the CCP would become liable when it steps in to manage the portfolio in the event of a default, as well as bid-ask costs associated with trading out of the positions.
Non-linear liquidity add-ons can be greater than the base initial margin for large positions, according to derivatives and margin analytics firm OpenGamma. Derivatives users can see their initial margin requirement jump by up to 40% when CCPs apply top-ups of this nature.
In the case of Aas, it is thought the prop trader had paid-up margin of just €60 million at the time of his default, out of a margin pool that had been worth €1.5 billion on March 31. When he was wiped out, Nasdaq chose to apply a reserve to the auctioned position, which was not met at the first attempt, meaning the auction was rerun the next day, exposing the firm to further costs.
How did the exchange let this guy have such concentrated positions? He pretty much had 50% of all open interest in the spread position
Former head of CCP due diligence at a major bank
While some CCPs apply an add-on that scales in a linear fashion in relation to increased concentration, for others the scaling is exponential – meaning that margin becomes increasingly punitive for large positions, also taking into account broader market conditions.
Nasdaq says its concentration add-on methodology is based on “a linear scaling of initial margin, where the size of the scaling factor depends on which threshold is surpassed.”
The head of clearing at one European bank argues that sizing top-ups solely as a factor of required margin may be too limited an approach, however.
“Concentration add-ons should be thought of in terms of the size of a position versus how much volume is typically traded on a daily basis, as opposed to a percentage of margin basis, as that can mask what the real liquidity is,” he says.
The head of clearing at one large US bank agrees Nasdaq “missed the boat” by failing to apply a concentration add-on.
But in the absence of a quantitative regulatory standard for calculating concentration add-ons, CCPs differ in how they incorporate market liquidity risk within default waterfalls. A minority of CCPs appear to apply concentration add-ons rarely or, in some cases, not at all, particularly in listed derivatives clearing, according to reports from supranational watchdogs.
“Most CCPs apply some form of concentration or liquidity add-ons in respect of over-the-counter derivatives products. The practice is more varied for exchange-traded derivatives, where in some cases these add-ons are either not applied or at least not applied on a routine basis,” a report by CPMI-Iosco found recently.
Gary Saunders, head of EMEA clearing at Barclays, argues greater regulatory standardisation around how CCPs think about concentration of positions may be necessary, just as regulators have set minimum standards for margin periods of risk for cleared OTC derivatives.
“Some kind of international standardisation around how we think about liquidity of positions and concentration margin would be helpful,” he says.
CCPs, however, see problems with such an approach. Finbarr Hutcheson, president of Ice Clear Europe, argues applying prescriptive rules would be a “blunt” approach: “It is hard to write requirements that are universally applicable. Principles for financial market infrastructures – broad standards that can be applied across different products, asset classes and services – are better.”
The head of derivatives at a central counterparty agrees it would be difficult to apply a general add-on formula across products that have idiosyncratic risk profiles.
Currently, CCPs are free to take different approaches to calculating margin add-ons. Eurex Clearing says its concentration add-ons for swaps and futures are exponential. However, the bourse is in the process of making a recalibration to its interest rates clearing model, which it says is part of a regular review to the model’s liquidity risk add-on parameterisation, rather than a fundamental shift in the model itself.
The head of clearing at one large US bank agrees Nasdaq “missed the boat” by failing to apply a concentration add-on
Following feedback from its regular liquidity survey, the change will make the concentration add-on scale more exponentially for large positions. Eurex Clearing chief risk officer Thomas Laux says the trigger for the change is increased volume in both forward rates agreements and in its swaps business, and that the clearing house is responding to member feedback on margin policies appropriate for larger positions. The change will be finalised at the end of this year.
CME Group has a number of approaches in its margin models to liquidity and concentration, which differ by product, and its concentration add-ons for futures, options and swaps are exponential. Its add-ons are calculated based on liquidity polls in various stressed scenarios held across the market.
“Our concentration add-ons take into account risk at the product level – through volume and open interest – as well as at the portfolio level,” says Lee Betsill, chief risk officer at CME Clearing. “We also apply a concentration add-on calculated relative to the size of the clearing member: those with lower financial resources face an add-on if positions get too large relative to their resources.”
Change in policy
In February, meanwhile, Ice Clear Europe announced a new policy on concentration add-ons. The clearing house has been using two separate concentration charge models – one for energy, and one for financials and soft agricultural commodities. For energy products, the new policy will result in “significantly increased concentration charges”, the bourse says.
Roger Storm, deputy head of CCP clearing at Six, says the bourse’s add-ons automatically kick in during its continuous recalculation of margin requirements throughout the day if a counterparty triggers certain thresholds during trading.
“Our model runs with a scaling factor. If a counterparty builds up a long position or has a concentrated collateral position, the more that rises – as measured by a combination of factors, including sector concentration – the more margin they need to bring. We scale that up and apply settlement limits – so, as positions are built, we have control points. Largely, the system automatically collects margins,” he tells Risk.net.
If a concentration limit is reached, Six has the option of manual intervention with the counterparty, says Storm: “We call them to tell them they have reached their limit. They may justify exceeding the limit because they have done countertrades. Then we will need to take a decision on that. And at the end of the day, we go back and test the adequacy of the margins and collateral.
“I’m not sure all CCPs – even in Europe – have established best practice on how to do this.”
LCH says it does not make its methodology for concentration add-ons available publicly beyond its membership base, and declined to comment further.