At FIA's Asia conference in Singapore on 29 November, a panel of experts discussed the future of clearing in volatile markets, with a focus on liquidity crises, collateral issues, and the prospects for tokenisation.
The panellists discussed the series of events over the last three years that have triggered large, sudden increases in margin requirements from derivatives clearinghouses, prompting concerns from both clearing members and their customers that some of these increases had acted in a procyclical manner, triggering or amplifying liquidity stress in the financial system.
“What recent events have exposed to some degree is procyclicality of margin and the inadequacy of margin from some CCPs around the world,” said David Martin, JP Morgan’s head of futures and derivatives clearing for Asia-Pacific.
“In times of stress, the biggest concern that we have with a change in CCP margin models is one of liquidity. It wasn't so much an issue for us in Asia, but I think this was really borne out particularly by the gilt crisis [in the UK] where you had capital-rich but liquidity-poor entities, very high up the credit spectrum, scrambling around trying to find margin. This is an aspect of volatility that is certainly top of our list,” Martin said.
The gilt crisis occurred in September 2022, when yields on 30-year UK government debt rose more than 1.60 percent. Pension funds had to quickly sell gilts in order to meet margin calls on interest rate swap and FX forward positions cleared at LCH. The selling pressure triggered by the margin calls led to a "rapid evaporation of gilt market liquidity" and a further rise in yields, forcing the Bank of England to intervene to restore market functioning, the central bank said in a post-crisis analysis in March.
Rohit Verma, head of Asia-Pacific at LCH, said he observed unusual behaviour from market participants during the gilt crisis and the so-called UK mini-budget.
“Our collateral pool is about 250 to 300 billion euros, and it has stayed within that range, but it was the behaviour that we saw change. Typically, the non-cash-to-cash ratio margin is 60/40. When the crisis hit, that flipped. We had 40% non-cash and people were trying to prepare for that liquidity. Cash became expensive because it was combined with a high interest rate environment, but people wanted to prioritise liquidity over cheapest-to-deliver collateral. That was an interesting behaviour,” he said.
“Our job is to empower clearing members and clients to prepare for that liquidity. From a CCP perspective what we also do is broaden the pool of eligible collateral,” Verma continued. “We look at adding non-cash collateral types from a region and we continue to do that thoughtfully in line with regulator partners and that helps with regional clients’ preparedness for volatile times.
“Anti-procyclicality floors is the solution to adequate initial margin, but if there is a big move, you have to pay the VM and that needs to be prepared,” he said.
Erik Tim Müller, chief executive officer at Eurex Clearing, saw similar behaviour from market participants during market events.
“In the moment of crisis, there is a tendency for more cash, because that's what you can immediately mobilise. We know Asia is even more cash-heavy than the rest of the world,” Müller said.
“Our observation is that as more and more asset classes and clients are drawn into exchanging IM and VM on a daily basis, what is not completely optimised yet is the access to liquidity for these end clients. It's come to a size in aggregate where I think we need alternative methods of turning securities into cash, and one of these is cleared repo. It's not the only solution, but I think we as an industry need to work on ways to help the end client turn high-quality securities into cash.”
Speaking about the Asia markets specifically, JP Morgan’s Martin said Asia was behind Western markets when it comes to the percentage of cash relative to security as collateral.
“There are lots of reasons for that. Regional exchanges are smaller, their P&L is smaller and their opportunities to innovate their systems are often harder, which means many Asian CCPs have been slower to accept securities collateral,” Martin said.
“The other thing that we see in Asia is that the fees for doing so are much higher than they are in other exchanges where I think there is good commercial dialogue, particularly around things like collateral usage fees.”
Ivan Han, executive director, deputy chief risk officer at SGX Group, said SGX accepts a flexible range of collateral, both cash and non-cash, and CCPs recognise that flexibility is important for members and customers. However, he warned that from a CCP perspective there is also a balance to strike “because taking a different range of collateral does require us to be more vigilant in monitoring the liquidity risks that we see in the market today.”
Another area discussed by panellists was the potential improvements to collateral treatment and settlement processes through tokenisation.
Tokenisation of assets refers to the process of issuing a digital token that represents ownership in a real asset with the potential to unlock new pools of liquidity to be used for margining. The token is issued on a distributed ledger and the transfer of ownership is recorded on that ledger, similar to how bitcoin transactions are recorded on the bitcoin blockchain.
“There are things that technology can solve for us, such as exploring ways around tokenisation of collateral and whether we can reduce the pain in the time lag in when a clearing member gets the money from his end client,” said Eurex Clearing’s Müller. “That's where technology can help us to explore and improve.”
The discussion at FIA Asia took place days before the Bank for International Settlements published a paper on the impact of CCPs increasing initial margin requirements for its members during times of stress. The paper notes that this may lead to “fire sales” in cash and derivative markets as investors dump assets to raise the needed funds, increasing volatility further and triggering additional rounds of margin calls.
In October 2020, FIA issued a white paper on the impact of volatility on CCP margin requirements and offered several solutions.