Margins and Financial Collateral for Derivatives Contracts: How to Deal with Procyclical Implications in a Financial Crisis

Abstract

One of the lessons to be learned from the financial crisis is that the mechanics of initial margins and collateral haircuts, applied to manage counterparty credit risk and market risk out of an outstanding position in derivatives, may cause significant perverse effects on the financial system by exacerbating the credit crunch and the volatility of financial markets. Conservative haircuts and margins are deemed, by regulators and academics, to preserve the stability of central counterparties (CCPs) and other relevant financial counterparties whereas no tools are envisaged to activate — via the use of such measures of mitigation of the risk borne in connection to derivatives exposures — virtuous devices to ‘overcome’ those phases of the financial markets characterised by high volatility in the prices of assets and liquidity shortage. After some notes on the state of the art in the relevant literature and a review of most recent international attempts to regulate the field of over-thecounter (OTC) derivatives, this paper aims to suggest some adjustments to the classical mechanisms used to manage derivatives credit and market risks, aimed at getting over part of the procyclical implications of their use. Building on the generally agreed assumption that margins on derivatives need to be conservative and stable through the cycle, the models and simulations presented in this work argue that a pre-set addon to the basic margin is not the optimal solution to the problem of procyclicality. Instead, a flexible add-on to the initial margin, as well as a flexible haircut to apply to collateral, could represent a preferable approach, although it is not completely immune from drawbacks. Such results are deemed to have some relevance in the context of derivatives contracts at a time when different efforts are being undertaken to regulate the field with the aim of remedying the shortcomings evidenced by the outcome of the financial crisis.

Keywords: margins, collateral, haircuts, procyclicality, central counterparty

JEL Classification: G01, G15