The Bank of England has urged clearing houses and large broker-dealers to publish their derivatives risk calculations, warning that more transparency was necessary to avoid future potential systemic risks.
The central bank, which monitors one of the world’s largest derivatives markets, sounded its warning in a white paper published on Friday that examined the impact of margin calls on stressed markets.
Margin is used by traders to back their derivatives trades but the amount they must post is based on a complex calculation of asset prices and market volatility made by the counterparty, usually a bank or clearing house.
The BoE found strong divergence in risk assessment, even in approved models, and raised concerns that traders would face a greater-than-expected calls for margin in volatile conditions.
It oversees the world’s largest over-the-counter derivatives markets as well as three London-based clearing houses — LCH. Clearnet, ICE Clear Europe and CME Europe. A fourth, owned by the London Metal Exchange, is due to open in September.
Although regulators have monitored risk models for decades, its importance has risen as global policymakers mandate that more over-the-counter derivatives trades be processed through privately owned clearing houses.
The risk manager, also known as a central counterparty (CCP), stands between two parties on a trade, ensuring the deal is completed in the event of a default.
Clearing houses are commercial businesses which offer differing margin requirements to win business. However, the BoE noted, their risk models are “procylical” — meaning they require more margin for derivatives portfolios times of market stress, which is also the most difficult time for traders to find more stable liquid assets.
The calls for margin are also unilateral and all members must meet it, which potentially puts more pressure on the financial system already under stress.
“We are mindful of not creating a liquidity risk where a credit risk used to be,” Edwin Schooling Latter, head of market infrastructure division, Financial Stability at the BoE, told the Financial Times. “It’s very important that clearing houses disclose properly the properties of their margin models. It is really important for market participants to understand the impact in stressed markets,” he said.
Initial margin models that passed standard risk-sensitivity tests could still vary “quite widely in their degree of procyclicality”, the report said.
Yet some clearing houses have pushed back on plans by global securities regulators to inject more transparency into the industry, arguing that their operations and market confidence could be damaged by publication of sensitive data.
“There isn’t much downside to margin models being publicly available and subject to a healthy amount of scrutiny and criticism,” said Mr Schooling Latter. “There’s a lot of scope to improve best practice and awareness, as well as an important systemic risk,” he said, adding that a lot more work needed to be done to build on internationally agreed standards.
The BoE also suggested that banks and authorities runs their own calculations over a period of a few weeks, or using a so-called peak-to-trough ratio, which shows the range of margin requirements over the business cycle.
— Financial Times