Central Clearing and Collateral Demand

We use an extensive data set of bilateral exposures on credit default swap (CDS) to estimate the impact on collateral demand of new margin and clearing practices and regulations. We decompose collateral demand for both customers and dealers into several key components, including the "velocity drag" associated with variation margin movements. We demonstrate the impact on collateral demand of more widespread initial margin requirements, increased novation of CDS to central clearing parties (CCPs), an increase in the number of clearing members, the proliferation of CCPs of both specialized and non-specialized types, and client clearing. Among other results, we show that system-wide collateral demand is increased significantly by the application of initial margin requirements for dealers, whether or not the CDS are cleared. Given these dealer-to-dealer initial margin requirements, however, mandatory central clearing is shown to lower, not raise, system-wide collateral demand, provided there is no significant proliferation of CCPs. Central clearing does, however, have significant distributional consequences for collateral requirements across various types of market participants.

Procyclicality of CCP Margin Models: Systemic Problems Need Systemic Approaches

A simple overlapping generations model is used to characterize the effects of initial margin requirements on the volatility of risky asset prices. Investors are assumed to exhibit heterogeneous preferences for risk-bearing, the distribution of which evolves stochastically across generations. This framework is used to show that imposing a binding initial margin requirement may either increase or decrease stock price volatility, depending upon the microeconomic structure behind fluctuations in economy-wide average risk-bearing propensity. The ambiguous effect on volatility similarly arises when the source of heterogeneity is noise trader beliefs. BEYOND THEIR PRUDENTIAL FUNCTIONS, the effects of initial margin requirements on securities markets are not well understood. Many have argued, based upon empirical findings, that the level of margin requirements has no discernable impact on stock price behavior.' Nevertheless, the view that high margin requirements dampen speculative excesses and reduce excess price volatility remains popular. The simultaneous existence of such views highlights the uncertainty surrounding this issue. In fact, there exists no rigorously articulated theory of the interaction between initial margin requirements and stock prices and their returns' characteristics. In this paper we construct a simple dynamic model useful for characterizing the effects of initial margin requirements on security prices and returns. To analyze the impact of margins, we introduce investor heterogeneity into an otherwise simplified overlapping generations (OLG) economy.2 The OLG models are constructed so that each generation displays heterogeneous preferences or beliefs, the distribution of which evolves stochastically across generations. In each of two heterogeneous taste models we consider there are two types of agents, one of which is more risk tolerant than the other. In one model, the

This article investigates the relationship between initial margin requirements and stock return volatility. Volatility is measured using a GARCH in Mean model. We find no evidence of an empirical relationship between margin requirements and the volatility of the S&P 500 index portfolio's excess returns. Evidence from short-sale data, and model sensitivity analysis are presented which support the hypothesis of no margin-volatility relationship. The results are consistent with the intertemporal CAPM model of Merton (1973) with an aggregate relative risk aversion measure of 4.1. In addition, we find evidence of long-term memory in conditional return distributions' volatility.

IN MY judgment," maintained William McChesney Martin, Jr., Chairman of the Board of Governors, Federal Reserve System, "we can never under the present margin regulations have the same result that occurred in terms of a financial crash in 1929 through undermargined accounts, low margins resulting in a financial debacle."' A widely used elementary economics textbook claimed, "Margin requirements have exercised an important restrictive influence on security speculation, as contrasted with the uncontrolled period of the late 1920's... Nearly everyone agrees that Federal Reserve margin requirements exercise a healthy restraint on speculative stock purchases in a boom" (Bach, 1963, p. 116). But what evidence is there that margin requirements have the effects claimed? At the December meetings of the American Economic Association, George J. Stigler, in the Presidential address, called on economists to test their assumptions that state regulation of private activity has indeed been successful (Stigler, 1965). This article brings together some data on the efficacy of margin requirements. While the figures can only be considered preliminary, and more data should be collected to test margin requirements, the data that are available and presented here indicate that not one of the aims of the legislation establishing margin requirements has been accomplished.2

The Interconnectedness and Systemic Importance in the U.S. CDS Market

The introduction of mandatory margining for non-cleared derivatives portfolios has major implications for the pricing and risk measurement of over-the-counter (OTC) derivatives. In particular, a model for estimating future initial margin requirements is necessary to enable the calculation of relevant pricing adjustments, net counterparty credit exposures and credit capital requirements. Existing literature on the topic suggests a model that makes use of regression techniques, but little detail is available on the predictive quality of these models within a Monte Carlo simulation framework. We review these regression-based initial margin models in detail and compare their output against the actual margin requirements measured by the International Swaps and Derivatives Association standard initial margin model (ISDA SIMM) methodology. We observe that the models generally perform well for single trades but show some degradation for larger diversified portfolios. We investigate potential extensions and improvements to the model, along with examining some additional ‘conservatism’ features that may have application in the context of credit exposure measurement. The initial margin modelling approaches discussed here are similarly applicable to centrally cleared or exchange-traded portfolios.

Estimating a Covariance Matrix for Market Risk Management and the Case of Credit Default Swaps

Credit default swaps (CDSs) are term insurance contracts written on traded bonds. This review studies the economics of CDSs using the economics of insurance literature as a basis for analysis. It is alleged that trading in CDSs caused the 2007 credit crisis, and therefore trading CDSs is an evil that needs to be eliminated or controlled. In contrast, I argue that the trading of CDSs is welfare increasing because it facilitates a more optimal allocation of risks in the economy. To perform this function, however, the risk of the CDS seller's failure needs to be minimized. In this regard, government regulation imposing stricter collateral requirements and higher equity capital for CDS traders needs to be introduced.

Hazardous Hedging: The (Unacknowledged) Risks of Hedging with Credit Default Swaps

CCP Clearing Demystified

Initial margin requirements represent: (1) a cost impediment to the wealth constrained investor and (2) a potential way of mitigating excessive volatility. However, prior empirical research finds that margins are not an effective tool in reducing volatility. We consider the possibility that margins primarily affect certain stocks and investors. Specifically, we test whether margins affect individuals who, as a group, we believe to be the investors most affected when margin requirements change. Our initial empirical tests, however, do not support this contention.

The financial structure of the derivatives insured by AIG with credit default swaps (CDS) was ultimately related to the systemic risk from the inability of the mortgagors to service their debts. AIG made several serious mistakes. First: The estimate of the drift of the capital gain, which drove the bubble, was based upon the unsustainable growth of the housing price index 2004–2006. A collapse would occur when the unsustainable capital gain declined below the interest rate. Second, risk was underestimated because AIG ignored the negative correlation between the capital gains and the liabilities/claims. The CDS claims grew when the value of the insured obligations declined. This set off collateral requirements, and the stability of AIG was undermined. The solution for the optimal insurance liabilities on the basis of SOC is derived. The SOC approach is a generalization of the contributions of the economics and actuarial literature. The chapter concludes with an evaluation of the government bailout.

This panel was held on Monday, January 28, 2013, at the ASF 2013 conference. Panelists discussed the developing impact of swap regulation on securitization and what it means for the ability to use swaps in securitization as new regulations take effect. The Dodd–Frank Act added a definition of the term “commodity pool,” and the Commodity Exchange Act revised the definition of the term “commodity pool operator.” As a result, many securitizations that held swaps, often solely to hedge interest rate or currency mismatches between their assets and their liabilities, were at risk of being considered commodity pools. By the time the panel took place, however, the Commodities Futures Trading Commission had granted two significant pieces of interpretive guidance and no-action relief that together excluded most traditional securitizations (e.g., credit card or auto loan securitizations), most asset-backed commercial paper programs, many CLOs and CDOs (collateralized loan obligations and collateralized debt obligations), and most covered bond transactions from the definition of a commodity pool. The panel focused on the relief that was granted and the issues that remained to be resolved. The panel also discussed the aspects of entering a swap that would be different for a securitization now than it would have been a year ago. The most significant changes have not yet become effective. Those include clearing and margin requirements and, eventually, a requirement to transact on a designated contract market or swap execution facility if the swap has been “made available to trade” on such a facility. One of the cornerstones of Dodd–Frank’s swap regulations is the requirement that swaps be cleared through a central counterparty. Whether a swap will need to be cleared depends on the identities of the counterparties, the nature of the swap, and whether a derivatives clearing organization is willing to clear it. Even if a swap is not required to be cleared, it may still be subject to margin requirements and margin calls. <b>TOPICS:</b>Interest-rate and currency swaps, credit default swaps

An international initiative to increase the use of central clearing for over-the counter (OTC) derivatives emerged as one of the reactions to the 2008 financial crisis. The move to central clearing is a fundamental change in the structure of the market. Central clearing will help control counterparty credit risk, but it also has potential implications for market liquidity. We analyze the relationship between liquidity and central clearing using information on credit default swap clearing at ICE Trust and ICE Clear Europe.We find that the central counterparty chooses the most liquid contracts for central clearing, consistent with liquidity characteristics being important in determining the safety and efficiency of clearing.We further find that the introduction of central clearing is associated with a slight increase in the liquidity of a contract. This is consistent with two countervailing effects. On the one hand, central clearing will likely increase collateral requirements relative to the prereform bilaterally cleared market, thereby increasing clearing costs and possibly reducing the liquidity of the market. On the other hand, improved management of counterparty credit risk, increased transparency and operational efficiencies at central counterparties could bring more competition into OTC derivative markets and serve to increase liquidity.