The Bank of England has recommended that central counterparties and major dealers disclose pro cyclicality properties in their margin calculations to help users anticipate potential margin calls and ensure they have adequate liquid assets.

The initial margin requirements for a derivatives portfolio are calculated using risk models which are procyclical so margin requirements increase in times of stress and decrease in calm markets. However this can cause systemic risk in financial markets as firms have to find additional liquid assets when it is most difficult for them to do so.

The Bank of England said in its latest Financial Stability Paper last week: “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.”

The Bank recommended three measures of pro cyclicality – the n-day measure, the n-day stressed measure and the peak-to-trough ratio.

The n-day measure calculates how much extra margin could be called over a few weeks to allow market participants to prepare to post additional collateral over a short period of time. The n-day stressed measure calculates potential increases in collateral requirements from these already high levels.

The peak-to-trough ratio shows the range of margin requirements for a portfolio over the business cycle.

The Bank said: “This could help market participants to evaluate whether the variation of collateral requirements was compatible with their business models. It could also help authorities to evaluate the scope for margin requirements across the financial system to rise relative to the available supply of collateral-eligible assets.”

The Bank said procyclicality will become more important as more products are centrally cleared.

The paper said: “This is a potential issue for both bilateral markets and cleared ones, as both use risk models to calculate margin requirements. The latter are however particularly a concern, first since clearing of many products either is or soon will be mandatory by many parties, and second since CCPs’ margin calls are unilateral: the CCP makes the call and all its members must meet it.”

The European Securities and Markets Authority has begun to authorise CCPs under the European Market Infrastructure Regulation as the region prepares for mandatory clearing of certain products.

Last month EuroCCP, the European equities clearer, became the second authorised CCP under Emir. Amsterdam-based EuroCCP was formed last December from the combination of the European Multilateral Clearing Facility in the Netherlands and European Central Counterparty Limited in the UK. It clears equities, exchange-trade funds and depositary receipts from 18 markets for 16 trading venues.

Diana Chan, chief executive of EuroCCP, has been pushing for for interoperability, or open access to clearing, in Europe so that investors are not forced to use the clearing house owned by the exchange where they execute trades.

She said told Markets Media last month: “In Europe 43% of the equity market is traded on Bats Chi-X and Turquoise and cleared by three interoperating CCPs. However, 24% of equity trades are cleared by only one or two of the interoperating CCPs, and we would like that 24% be cleared by all three interoperating CCPs.”

This week EuroCCP said that it will become the third CCP for trades executed on London Stock Exchange allowing users to cut settlement costs and net positions more efficiently.

Interoperability arrangements are already in place between EuroCCP and the two incumbent clearers for LSE – LCH.Clearnet and SIX x-clear.

EuroCCP will start clearing LSE trades after legal, connectivity and operational arrangements have been finalized and regulatory approvals have been received.

EuroCCP said in a statement: “Firms using EuroCCP to clear UK equities trades executed on Aquis, BATS Chi-X, Equiduct, GETMatched, Sigma-X, SmartPool, Turquoise and UBS MTF will be able to direct LSE trades to EuroCCP and save at least 50% on settlement costs. Through cross-platform netting by EuroCCP, all trades in the same UK stock, regardless of where they are executed, can be netted with LSE trades into one single settlement obligation.”

Cross-platform netting of UK equities by CCPs has been possible since 2013 for trades executed on multilateral trading facilities and it is expected that LSE trades can also be cross-platform netted from the third quarter of this year.

Featured image via Adrian Pingstone/ Wikimedia Commons