An Investigation into the Procyclicality of Risk-Based Initial Margin Models

19 Pages Posted: 17 May 2014

See all articles by David Murphy

David Murphy

London School of Economics - Law Department; Bank of England

Michalis Vasios

Norges Bank Investment Management (NBIM)

Nicholas Vause

Bank of England

Date Written: May 16, 2014

Abstract

The initial margin requirements for a portfolio of derivatives are typically calculated using a risk model. Common risk models are procyclical: margin requirements for the same portfolio are higher in times of market stress and lower in calm markets. This procyclicality can cause liquidity stress whereby parties posting margin have to find additional liquid assets, often at just the times when it is most difficult for them to do so. Hence regulation has recognised that, subject to being adequately risk sensitive, margin models should not be ‘overly’ procyclical. There is, however, no standard definition of procyclicality.

This paper proposes two types of quantitative measure of procyclicality: one that examines margin variation across the cycle and one that focuses on short-term margin increases. It then studies, using historical and simulated data, various margin models with regard to both their risk sensitivity and the proposed procyclicality measures. It finds that models which pass common risk sensitivity tests can have very different levels of procyclicality.

The paper recommends that CCPs and major dealers should disclose the procyclicality properties of their margin models, perhaps by reporting the proposed procyclicality measures. This would help derivatives users to anticipate potential margin calls and ensure they have adequate holdings of or access to liquid assets.

Suggested Citation

Murphy, David and Vasios, Michalis and Vause, Nicholas, An Investigation into the Procyclicality of Risk-Based Initial Margin Models (May 16, 2014). Bank of England Financial Stability Paper No. 29, Available at SSRN: https://ssrn.com/abstract=2437916 or http://dx.doi.org/10.2139/ssrn.2437916

David Murphy

London School of Economics - Law Department

Houghton Street
London WC2A 2AE, WC2A 2AE
United Kingdom

Bank of England ( email )

Threadneedle Street
London, EC2R 8AH
United Kingdom

Michalis Vasios (Contact Author)

Norges Bank Investment Management (NBIM) ( email )

Queensberry House
3 Old Burlington Street
London, W1S 3AE
United Kingdom

Nicholas Vause

Bank of England ( email )

Threadneedle Street
London, EC2R 8AH
United Kingdom

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