Margin call disparity, breaches could drive clearinghouse scrutiny, says Fitch

The largest global clearinghouses (CCPs) demonstrated the resilience of their credit and liquidity profiles in early 2020 despite a spike in market volatility and unprecedented operational disruptions driven by economic fallout from the global pandemic, Fitch Ratings says. 

The broad introduction of central clearing, promoted by post-2008 financial crisis regulations, helped preserve the orderly functioning of and confidence in global CCPs amid the coronavirus turmoil. However, the magnitude and disparity of margin increases also highlighted the risk of increased pro-cyclicality and interconnectedness of the markets, which could drive further regulatory scrutiny.

In 1Q20, the number and aggregate value of margin breaches of CCPs increased 115 per cent and 450 per cent from the prior quarter, respectively, when intraday price movements exceeded initial margins posted by counterparties. However, Fitch views the reported breaches as manageable relative to CCPs' variation margin frameworks, close-out procedures in the event of counterparty default, sizeable guaranty funds and other available resources. Margin calls are CCPs' primary tool to manage counterparty risk during periods of increased market volatility.

Fitch estimates that, relative to 4Q19, up to USD150 billion in additional margins were called by CCPs on a single day in March 2020. An inability to cover one-day market changes with initial margins exposes CCPs to losses in the event of a counterparty default. Only a few defaults were reported by smaller clearing members in 1Q20 despite the backdrop of price volatility and operational disruption, with no losses reported to CCPs' collective default funds.

The largest global CCPs reported their highest exposure levels in 1Q20 since disclosures began in 4Q15. Aggregate peak initial and variation margin calls on a single day, reported by a group of global CCPs, rose 182 per cent from 4Q19 to $223 billion in 1Q20, demonstrating how CCP-driven liquidity demands can contribute to or exacerbate a liquidity squeeze across the entire system during a volatile period.

CCPs' initial margins increased more significantly for exchange-traded derivatives (ETDs) than for over-the-counter (OTC) derivatives. The difference can be explained by the fact that most cleared OTC products are interest rate swaps, whereas ETDs represent a variety of asset classes, including commodities, equities and equity indexes, which have historically been more volatile.

Margins held at CCPs tend to be concentrated with the largest counterparties, particularly at US derivatives clearinghouses (CME, OCC), where top-10 clearing members account for over 75 per cent of total exposure. Most of the liquidity burden of the margin increases was borne by a handful of these large institutions that are clearing members at the CCPs. The largest banks, which are the CCPs' key clearing members, benefited from the unprecedented fiscal and monetary policies implemented by most G7 governments and central banks. This helped mitigate the effects of the economic fallout due to the global pandemic and supported the liquidity of most asset classes.

Further regulatory scrutiny of CCP margin models is expected given the extent and disparity of margin increases by CCP and reported breaches in early 2020. For example, the OCC's peak daily margin increased 663 per cent in 1Q20 relative to its average in 4Q15-4Q19, with the LCH increasing by a lesser, but still substantial, 253 per cent.

The margin disparities were largely driven by differences in the various CCP models' assumptions, such as the time period selected to measure historical volatility or the look-back period, with shorter look-back periods likely to be more pro-cyclical. Various solutions can be considered to limit pro-cyclicality, like mandating longer look-back periods, instituting margin floors, exhaustible pro-cyclicality buffers or limiting margin increases during stress. Fitch believes consistent and more substantial anti-pro-cyclicality margin components would be positive for CCP credit profiles and systemic stability.