Financial Stability Standards for Central Counterparties – December 2012 Standard 6: Margin

Guidance

An effective margining system is a key risk management tool for a central counterparty to manage the credit exposures associated with its participants' open positions (see also CCP Standard 4 on credit risk). A central counterparty should collect margin, which is a deposit of collateral in the form of money, securities or other financial instruments, to mitigate its credit exposures for all products that it clears in the event of a participant default (see also CCP Standard 5 on collateral). Margin systems typically differentiate between initial margin and variation margin.^[1] Initial margin is typically collected to cover potential changes in the value of each participant's position (that is, potential future exposure) over the appropriate close out period in the event the participant defaults. Calculating potential future exposure requires modelling potential price movements and other relevant factors, as well as specifying the target degree of confidence and length of the close out period. Variation margin is collected and paid out to reflect current exposures resulting from actual changes in market prices. To calculate variation margin, open positions are marked to current market prices and funds are typically collected from (or paid to) a counterparty to settle any losses (or gains) on those positions.

6.1.1 When setting margin requirements, a central counterparty should have a margin system that establishes margin levels commensurate with the risks and particular attributes of each product, portfolio and market it serves. Product risk characteristics can include, but are not limited to, price volatility and correlation, non-linear price characteristics, jump-to-default risk, market liquidity, possible liquidation procedures (for example, tender by or commission to market-makers), and correlation between price and position such as wrong-way risk.^[2] Margin requirements need to account for the complexity of the underlying instruments and the availability of timely, high-quality pricing data. For example, OTC derivatives may require more conservative margin models because of their complexity and the greater uncertainty of the reliability of price quotes. Furthermore, the appropriate close out period may vary among products and markets depending upon the product's liquidity, price and other characteristics. Additionally, a central counterparty for cash markets (or physically deliverable derivatives products) should take into account the risk of ‘fails to deliver’ of securities (or other relevant instruments) in its margin methodology. In a fails-to-deliver scenario, the central counterparty should continue to margin positions for which a participant fails to deliver the required security (or other relevant instrument) on the settlement date.

6.2.1 A central counterparty should have a reliable source of timely price data because such data are critical for a central counterparty's margin system to operate accurately and effectively. In most cases, a central counterparty should rely on market prices from continuous, transparent and liquid markets. If a central counterparty acquires pricing data from third-party pricing services, the central counterparty should continually evaluate the reliability and accuracy of the data. A central counterparty should also have procedures and sound valuation models for addressing circumstances in which pricing data from markets or third-party sources are not readily available or reliable. A central counterparty should have its valuation models validated under a variety of market scenarios at least annually by a qualified and independent party to ensure that its model accurately produces appropriate prices, and, where appropriate, the central counterparty should adjust its calculation of initial margin to reflect any identified model risk.^[3] A central counterparty should address all pricing and market liquidity concerns on an ongoing basis to support the daily measurement of its risks.

6.2.2 For some markets, prices may not be reliable because of the lack of a continuous liquid market. Although independent third-party sources would be preferable, in some cases participants may be an appropriate source of price data, as long as the central counterparty has a system that ensures that prices submitted by participants are reliable and accurately reflect the value of cleared products. Moreover, even when quotes are available, bid-ask spreads may be volatile and widen, particularly during times of market stress, thereby constraining the central counterparty's ability to measure accurately and promptly its exposure. In cases where price data are not available or reliable, to determine appropriate prices a central counterparty should analyse historical information about actual trades submitted for clearing and indicative prices (such as bid-ask spreads), as well as the reliability of price data, especially in volatile and stressed markets. When prices are estimated, the systems and models used for this purpose must be subject to annual validation and testing. As a general rule, margin settings should, other things being equal, be higher where price data are relatively less timely or reliable.

6.3.1 The method selected by the central counterparty to estimate its potential future exposure should be capable of measuring and incorporating the effects of price volatility and other relevant product factors and portfolio effects over a close out period that reflects the market size and dynamics for each product cleared by the central counterparty.^[4] The estimation may account for the central counterparty's ability to implement effectively the hedging of future exposure. The method selected by the central counterparty should take into account correlations across product prices, market liquidity for close out or hedging, and the potential for non-linear risk exposures posed by certain products, including jump-to-default risks. Where a central counterparty calculates margin at the sub-portfolio level or by product, initial margin requirements must be met for the corresponding distributions of future exposure at a stage prior to margining among sub-portfolios or products. A central counterparty should have the authority and operational capacity to make intraday initial margin calls, both scheduled and unscheduled, to its participants.

6.3.2 A central counterparty should select an appropriate close out period for each product that it clears and document the close out periods and related analysis for each product type. A central counterparty should base its determination of the close out periods for its initial margin model upon historical price and liquidity data, as well as reasonably foreseeable events in a default scenario. The close out period should account for the impact of a participant's default on prevailing market conditions. Inferences about the potential impact of a default on the close out period should be based on historical adverse events in the product cleared, such as significant reductions in trading or other market dislocations. The close out period should be based on anticipated close out times in stressed market conditions but may also take into account a central counterparty's ability to hedge effectively the defaulter's portfolio. Further, close out periods should be set on a product-specific basis because less liquid products might require significantly longer close out periods. As a general guide, a central counterparty should assume a close out period of at least two business days, or at least five business days for less liquid markets. A central counterparty should also consider and address position concentrations, which can lengthen close out time frames and add to price volatility during close outs.

6.3.3 A central counterparty should select an appropriate sample period for its margin model to calculate required initial margin for each product that it clears and should document the period and related analysis for each product type. The amount of margin may be very sensitive to the sample period and the margin model. Selection of the period should be carefully examined based on the theoretical properties of the margin model and empirical tests on these properties using historical data. In certain instances, a central counterparty may need to determine margin levels using a shorter historical period to reflect new or current volatility in the market more effectively. Conversely, a central counterparty may need to determine margin levels based on a longer historical period in order to reflect past volatility. A central counterparty should also consider simulated data projections that would capture plausible events outside of the historical data especially for new products without enough history to cover stressed market conditions.

6.3.4 A central counterparty should identify and mitigate any credit exposure that may give rise to specific wrong-way risk. For example, participants in a central counterparty clearing credit default swaps should not be allowed to clear single-name credit default swaps on their own names or on the names of their legal affiliates. A central counterparty is expected to review its portfolio regularly in order to identify, monitor and mitigate promptly any exposures that give rise to specific wrong-way risk.

6.3.5 A central counterparty should appropriately and where practicable address procyclicality in its margin arrangements (see CCP Standard 5.4). In this context, procyclicality typically refers to changes in risk management practices that are positively correlated with market, business or credit cycle fluctuations and that may cause or exacerbate financial instability. For example, in a period of rising price volatility or credit risk of participants, a central counterparty may require additional initial margin for a given portfolio beyond the amount required by the current margin model. This could exacerbate market stress and volatility further, resulting in additional margin requirements. These adverse effects may occur without any arbitrary change in risk management practices. To the extent practicable and prudent, a central counterparty should adopt forward-looking and relatively stable and conservative margin requirements that are specifically designed to limit the need for potentially destabilising, procyclical changes. To support this objective, a central counterparty could consider increasing the size of its prefunded default arrangements to limit the need for and likelihood of large or unexpected margin calls in times of market stress. These procedures may create additional costs for central counterparties and their participants in periods of low market volatility due to higher margin or prefunded default arrangement contributions, but they may also result in additional protection and potentially less costly and less disruptive adjustments in periods of high market volatility. In addition, transparency regarding margin practices when market volatility increases may help mitigate the effects of procyclicality.

Variation margin

6.4.1 A central counterparty faces the risk that its exposure to its participants can change rapidly as a result of changes in prices, positions, or both. Adverse price movements, as well as participants building larger positions through new trading, can rapidly increase a central counterparty's exposures to its participants (although some markets may impose trading limits or position limits that reduce this risk). A central counterparty can ascertain its current exposure to each participant by marking each participant's outstanding positions to current market prices. To the extent permitted by a central counterparty's rules and supported by law, the central counterparty should net any gains against any losses and require frequent (at least daily) settlement of gains and losses. This settlement should involve the daily (and, when appropriate, intraday) collection of variation margin from participants whose positions have lost value and can include payments to participants whose positions have gained value. The regular collection of variation margin prevents current exposures from accumulating and mitigates the potential future exposures a central counterparty might face. A central counterparty should also have the authority and operational capacity to make intraday variation margin calls and payments, both scheduled and unscheduled, to its participants. A central counterparty should consider the potential impact of its intraday variation margin collections and payments on the liquidity position of its participants and should have the operational capacity to make intraday variation margin payments.

Timeliness and possession of margin payments

6.4.2 A central counterparty should establish and rigorously enforce timelines for margin collections and payments and set appropriate consequences for failure to pay on time. Margin should be held by the central counterparty until the associated exposure has been extinguished; that is, margin should not be returned before settlement or close out of an exposure is successfully concluded.

Portfolio margining

6.5.1 In calculating margin requirements, a central counterparty may allow offsets or reductions in required margin amounts between products for which it is the counterparty if the risk of one product is significantly and reliably correlated with the risk of another product.^[5] A central counterparty should base such offsets on an economically meaningful methodology that reflects the degree of price dependence between the products. Often, price dependence is modelled through correlations, but more complete or robust measures of dependence should be considered, particularly for products with non-linear risks. In any case, the central counterparty should consider how price dependence can vary with overall market conditions, including stressed market conditions. Following the application of offsets, the central counterparty needs to ensure that the margin continues to meet or exceed the single-tailed confidence level of at least 99 per cent with respect to the estimated distribution of the future exposure of the portfolio. If a central counter party uses portfolio margining, it should continuously review and test offsets among products. It should test the robustness of its portfolio method on both actual and appropriate hypothetical portfolios. It is especially important to test how correlations perform during periods of actual and simulated market stress to assess whether the correlations break down or otherwise behave erratically. Prudent assumptions informed by these tests should be made about product offsets.

Cross-margining

6.5.2 A central counterparty may enter into a cross-margining arrangement, which is an agreement with one or more other central counterparties to consider positions and supporting collateral at their respective organisations as a common portfolio for participants that are members of two or more of the organisations (see also CCP Standard 19 on FMI links). A central counterparty may reduce the aggregate collateral requirements for positions held in cross-margined accounts if the value of the positions held at the parties to the cross-margining arrangement move inversely in a significant and reliable fashion.

6.5.3 A central counterparty that participates in a cross-margining arrangement must share information frequently with other central counterparties in the arrangement and ensure that it has appropriate safeguards, such as joint monitoring of positions, margin collections and price information. The central counterparty must thoroughly understand the other central counterparties' respective risk management practices and financial resources. The central counterparty should also take steps to harmonise its overall risk management systems with those of the other central counterparties, and should regularly monitor possible discrepancies in the calculation of exposures, especially with regard to monitoring how price correlations perform over time. This harmonisation is especially relevant in terms of selecting an initial margin methodology, setting margin parameters, segregating accounts and collateral, and establishing default management arrangements. All of the precautions with regard to portfolio margining discussed in paragraph 6.5.1 also apply to cross-margining regimes between or among central counterparties. A central counterparty that is party to a cross-margining arrangement should also analyse fully the impact of cross-margining on prefunded default arrangements and on the adequacy of its overall financial resources. Each participating central counterparty should have in place arrangements that are legally robust and operationally viable to govern the cross-margining arrangement.

6.5.4 A central counterparty should consult with the Reserve Bank prior to entering into a cross-margining arrangement with another central counterparty. The central counterparty should be able to demonstrate the safeguards it has in place and provide information regarding its risk management systems and those of the other central counterparties involved in the cross-margining arrangement. Prior to entering into the cross-margining arrangement, the central counterparty should ascertain that the Reserve Bank is satisfied that to do so would not weaken its compliance with the CCP Standards, and should implement any additional controls or mitigants identified in consultation with the Reserve Bank.

6.6.1 In order to validate its margin models and parameters, a central counterparty should have a backtesting program that tests its initial margin models against identified targets. Backtesting is an ex post comparison of observed outcomes with the outputs of the margin models. A central counterparty should also conduct sensitivity analysis to assess the coverage of the margin methodology under various market conditions, using historical data from realised stressed market conditions and hypothetical data for unrealised stressed market conditions. Sensitivity analysis should also be used to determine the impact of varying important model parameters. Sensitivity analysis is an effective tool to explore hidden shortcomings that cannot be discovered through backtesting. The results of both the backtesting and sensitivity analyses should be disclosed to participants.

6.6.2 A central counterparty should backtest its margin coverage using participant positions from each day in order to evaluate whether there are any exceptions to its initial margin coverage. This assessment of margin coverage should be considered an integral part of the evaluation of the model's performance. Coverage should be evaluated across products and participants and take into account portfolio effects across asset classes within the central counterparty. The initial margin model's actual coverage, along with projected measures of its performance, should meet at least the established single-tailed confidence level of 99 per cent with respect to the estimated distribution of future exposure over an appropriate close out period.^[6] In case backtesting indicates that the model did not perform as expected (that is, the model did not identify the appropriate amount of initial margin necessary to achieve the intended coverage), a central counterparty should have clear procedures for recalibrating its margining system, such as by making adjustments to parameters and sampling periods. In addition, a central counterparty should analyse the source of any exceptions to initial margin coverage identified through backtesting, to determine if a fundamental change to the margin methodology is warranted or if only the recalibration of current parameters is necessary. Backtesting procedures alone are not sufficient to evaluate the effectiveness of models and adequacy of financial resources against forward-looking risks.

6.6.3 A central counterparty should test the sensitivity of its margin model coverage using a wide range of parameters and assumptions that reflect possible market conditions in order to understand how the level of margin coverage might be affected by highly stressed market conditions. The central counterparty should ensure that the range of parameters and assumptions captures a variety of historical and hypothetical conditions, including the most volatile periods that have been experienced by the markets it serves and extreme changes in the correlations between prices. The central counterparty should conduct sensitivity analysis incorporating stressed market conditions on its margin model coverage at least monthly and conduct a thorough analysis of the potential losses it could suffer. A central counterparty should evaluate the potential losses in individual participants' positions and, where appropriate, their customers' positions. Furthermore, for a central counterparty clearing credit instruments, parameters reflective of the simultaneous default of both participants and issuers of the underlying credit instruments should be considered. Sensitivity analysis should be performed on both actual and simulated positions. Rigorous sensitivity analysis of margin requirements may take on increased importance when markets are illiquid or volatile. This analysis should be conducted more frequently when markets are unusually volatile or less liquid or when the size or concentration of positions held by its participants increases significantly.

6.7.1 A central counterparty's margin methodology should be reviewed and validated by a qualified and independent party at least annually, or more frequently if there are material market developments. Any material revisions or adjustments to the methodology or parameters should be subject to appropriate governance processes (see also CCP Standard 2 on governance) and validated prior to implementation. A central counterparty that is party to a cross-margining arrangement should also analyse the impact of cross-margining on prefunded default arrangements and evaluate the adequacy of its overall financial resources (see CCP Standard 6.5). Also, the margin methodology, including the initial margin models and parameters used by a central counterparty, should be made as transparent as possible. At a minimum, the basic assumptions of the analytical method selected and the key data inputs should be disclosed to participants. A central counterparty should make details of its margin methodology available to its participants for use in their individual risk management efforts.

6.8.1 A central counterparty with participants in a range of time zones may need to adjust its procedures for margining (including the times at which it makes margin calls) to take into account the liquidity of a participant's local funding market and the operating hours of relevant payment and settlement systems. The extent to which a central counterparty's margining procedures should take into account local operating hours in a particular jurisdiction will depend on the extent of local participation and the relative costs of any adjustments required to its operations. A central counterparty with material Australian-based participation that clears Australian dollar-denominated products for which the greatest depth of liquidity is in Australian markets should consider making margin calls during Australian market hours and in Australian dollars.