When derivatives markets become more volatile, everyone agrees that margin requirements must go up. But how much higher? Set margins too high, and trading becomes too expensive. Set margins too low, and traders take too much risk. It's the Goldilocks problem – margin needs to be just right.
Initial margin functions as the first line of defense against a default. It protects the derivatives markets from losses when a trader takes too much risk and cannot cover his or her losses. Getting it right is therefore critical to ensuring that traders have the right incentives to manage their risks and that the rest of the market is protected when they get it wrong.
Let's be clear: The derivatives clearing system has performed well during exceptional volatility and trading volume over the last few years, starting with the COVID-19 pandemic and through the latest disruptions in commodity markets sparked by war in Ukraine. I am encouraged by how well the derivatives markets have held up in the face of unprecedented challenges.
But there is always room for improvement. And FIA has been proud of its central role in providing a forum for various parties across the trading lifecycle to come together and discuss best practices and areas of opportunity.
This is one of the reasons why we strongly support a recent proposal from the European Securities and Markets Authority (ESMA) to review its standards for the setting of margin requirements. The proposal addresses a specific issue – procyclicality. What is this concept? To put in plain English, if margins are set too low and lurch too quickly, they can trigger a dash for cash among market participants that exacerbates volatility. Rather than serving as a shock absorber of risk, margin levels that are too procyclical can contribute stress to an already stressed financial system.
Regulators have been worried about this risk for years, but it didn't really get much attention until the Covid crisis hit the financial markets. The global economic shutdown and abrupt reversal in prices for stocks, bonds and commodities triggered a massive increase in volatility, and in response, the clearinghouses increased their margin requirements. That was the right move, but it led to a huge increase in the amount of initial margin posted to clearinghouses.
In late 2020, we issued a white paper quantifying the scope of margin increases in the early days of the pandemic, and we offered a clear-eyed analysis of the way forward. As I said publicly at the time, FIA's analysis proved that the system worked, but also it was strained. As an industry, we must look at those strains and make the adjustments needed to avoid undue pressure on liquidity.
We weren't the only ones who noticed. The global standard-setting bodies – the Basel Committee, the Financial Stability Board, and the International Organization of Securities Commissioners – published a review of margining practices in October 2021 that confirmed our concerns. According to their review, the total initial margin requirement across all CCPs increased by roughly $300 billion during March 2020. Looking at just exchange-traded derivatives, the total IM requirement increased by roughly $200 billion, about two-thirds of the total. In percentage terms, the total IM for exchange-traded derivatives increased by 62% in a single month.
That is a huge increase in a very short time. The good news is that clearing members were able to meet those margin calls. But the sudden demand for liquidity put a lot of pressure on their ability to fund those calls, and as we said in our report, we need to find ways to reduce the procyclicality of margin models.
To its credit, ESMA took the bull by the horns in January and proposed specific requirements for clearinghouses. In our response, FIA again leaned on the experience of our members and the data at our disposal to suggest potential improvements. We don't agree with everything in the proposal, but we strongly support the core idea – margin requirements must not fall too low when markets are calm and then spike during times of stress.
There are many ideas out there worthy of consideration and debate from margin floors to improved model transparency to standardizing intraday margin calls at clearinghouses. FIA is eager to continue the conversation on anti-procyclicality measures and help guide the industry towards a Goldilocks solution on margin that makes our markets safer and more resilient.