Banks, CCPs protest Esma’s ‘prescriptive’ procyclicality rules

Dealers welcome model transparency push, but call for greater say on methods to combat spikes

Esma headquarters, Paris
Esma headquarters, Paris
Photo: Esma

Banks and clearing houses alike are railing against “prescriptive” new rules proposed by European regulators to curb spikes in initial margin (IM) at central counterparties (CCPs) during times of severe market stress.

Almost two years after the rapid spread of the coronavirus sent shockwaves through markets, and saw margins spike dramatically for many assets, the European Securities and Markets Authority (Esma) proposed amendments to European Union rules on January 27 aimed at preventing a repeat of such episodes.

After taking into account the results of a consultation, which expires on March 31, the final proposal will aid European Commission (EC) amendments to existing regulatory technical standards that guide the implementation of the European Market Infrastructure Regulation (Emir).

But industry bodies Each and the International Swaps and Derivatives Association both tell that the proposed rules risk tying the hands of CCPs as they try to manage a range of risks that can vary significantly from market to market. 

“We really think an outcomes-based approach is best,” says Ulrich Karl, head of clearing at Isda. “You define a desired outcome, you measure how the CCP achieves the outcome, and then you leave it to the CCPs to implement it however they please.”

Karl suggests that Esma’s approach is at least partly driven by the underlying Emir legislation, which is “quite prescriptive”.

Despite these reservations, clearing banks expressed strong support for proposals that would see CCPs forced to reveal more information about how margin models are constructed – something many have long called for alongside existing disclosure requirements.

We really think an outcomes-based approach is best. You define a desired outcome, you measure how the CCP achieves the outcome, and then you leave it to the CCPs to implement it however they please

Ulrich Karl, Isda

Emir mandated Esma to draft regulatory technical standards that set the “appropriate percentage and time horizons for the liquidation period and the calculation of historical volatility” for IM models. Given that the legislation itself asks Esma for precise numbers, the regulator must be at least somewhat prescriptive in its advice to the EC.

Rafael Plata, general secretary of CCP trade body Each, agrees that Esma’s proposed approach risks being seen as too granular and prescriptive by clearers.

Ulrich Karl
Ulrich Karl, Isda

“Esma keeps repeating in the consultation that they want to provide flexibility to CCPs, which we welcome, but we are analysing whether some proposals may lead to more granularity than flexibility,” he says.

CCP procyclicality became a hot topic after the pandemic-induced volatility of March 2020, which saw clearing houses scramble to increase IM coverage, as large calls came in with markets whipsawing.

Clearing banks and some large buy-side firms, including BlackRock, warned that margins had been set too low before the pandemic, resulting in margins increasing substantially at a difficult time for the market. The evidence for this, they said, was the large amount of contract-level margin breaches seen regularly at many CCPs, where variation margin called on a day exceeds the total amount of IM.

Esma’s proposals, if enacted close to their current form, would mark a significant change to the way anti-procyclicality is regulated, say market participants. Currently, EU clearing houses have to choose one of three minimum standards to control procyclicality.

The first is a margin buffer of at least 25% of margins, which, in theory, can be exhausted during stressed periods. The second is giving a model a 25% weighting to stressed periods in history when calculating margins, which otherwise would be wholly dependent on near-term data. The last is a margin floor based on observed volatility over a 10-year lookback period.

Each’s Plata worries some of the language in the consultation may prompt a monolithic approach to risk management, and too much prescriptiveness.

For instance, Esma writes that during the Covid-19 stressed period in March of 2020, “margin models have reacted differently, with some models performing in a more procyclical manner than others”. Plata warns that Esma’s concern about this is “very scary if they mean that CCPs’ models should be increasingly similar”, pointing out the narrower the options available to clearers, the more likely it is their shared member base will “incur model risk”.

In the consultation, Esma does acknowledge that differences between model performance are to a “certain extent” driven by the characteristics of the underlying asset class.

Rafael Plata
Rafael Plata, Each

A source at a large US clearing bank and Each’s Plata do warn of elements of prescriptiveness further on in the paper. For instance, the paper says that CCPs “shall avoid using scaling techniques that can affect the severity of observations, extreme market movements or calculated floor margin”. It also says that CCPs shall also “consider” including “potential future scenarios” in their models.

For example, it recommends the use of potential future and historical volatile scenarios for the calculation of an IM floor. Esma also recommends making use of scenarios already used for the calculation of the CCP’s default fund. It also recommends against using any “scaling techniques” that could affect the severity of these scenarios, bringing the floor down lower.

The clearing bank source suggests that some products are “incredibly complex”, whereas some products are “very simple and very liquid”, arguing for a more hands-off approach that would let individual CCPs choose the best model that works for them.

“The CCP should pick whatever scenarios they want,” says the clearing bank source. “You need standardised reporting. Through our discussions with the CCP, they need to highlight why they chose option A, B or C, and how that works best for that product. That [chosen] approach may very well be one of the tools recommended by Esma, but it’s not necessarily only one of those tools.”

Clearing banks are happier, however, about proposed changes to transparency requirements around CCP margin model construction. Many of the amendments include more granular detail of how CCPs must document and justify their approach to procyclicality, including any metrics they use to measure procyclicality, the frequency with which they assess their approach, governance arrangements that determine its policy and public disclosure of the information necessary to assess a CCP’s performance.

Isda’s Karl and the bank clearing source agree that these are positive changes to hold CCPs accountable. But they both call for it to be made clear that members should be consulted on the exact policies used by CCPs to manage procyclicality.

Esma, however, suggests in the consultation that it doesn’t want to issue any recommendations related to reporting and disclosures yet, as the Committee on Payments and Market Infrastructures, International Organization of Securities Commissions and Basel Committee on Banking Supervision are consulting on this topic.

CCPs are closely watching the outcome of Esma’s consultation. While technically in EU law, the existing rules on procyclicality have become a de facto standard for many global CCPs, such as CME Group.

Across the pond, the US has seen little change in CCP approaches to procyclicality since the pandemic roiled markets in 2020. While market participants did convene in the market risk advisory committee of the Commodity Futures Trading Commission to discuss potential changes, banks argue the changes are not substantial.

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