Draft supervisory statement on CCP margin

1: Introduction

1.1 This Supervisory Statement (SS) is relevant to all Bank of England (Bank) supervised central counterparties (CCPs) and UK entities that are planning to apply to the Bank for an authorisation as a UK CCP. It primarily explains the Bank’s supervisory expectations in relation to CCPs’ management of initial margin procyclicality, including in the design and review of regulatory initial margin models, and in relation to portfolio margining. In addition, the SS sets out guidance in relation to CCPs’ provision of a margin simulation tool and the requirement to continuously monitor margin.

1.2 The Bank considers that large, unexpected changes in initial margin requirements can act as a propagator to liquidity strains faced by participants in centrally cleared markets and, as a consequence, contribute to financial stability risks. The policy objective of this SS is for CCPs to consider in full the potential impacts of margin model design and margin model revisions on the procyclicality of their initial margin requirements, and to observe a prudent approach to portfolio margining. This SS contains a set of principles that the Bank expects CCPs to observe in order to develop a robust framework for considering margin model performance in a holistic manner and to apply portfolio margining. Taken together, the aim of this framework is to ensure that CCPs limit the need for destabilising, procyclical changes, to the extent practicable and prudent, and apply portfolio margining in a prudent manner.

1.3 This SS is structured around the Bank’s rules on CCP management of margin procyclicality and portfolio margining and sets out the Bank’s expectations on how CCPs should apply these rules, where relevant. More specifically, this SS complements, and should be read in conjunction with the following provisions of the Bank of England FMI Rulebook: UK Central Counterparties Instrument (CCP rules):

1. Margin Requirements Part, rules 3.17-3.27 (Procyclicality)
2. Review and Testing of Models and Parameters Part, rule 3.2 (Model validation)
3. Margin Requirements Part, rules 2.10-2.15 (Portfolio margining)
4. Margin Requirements Part, rules 5.1-5.3 (Margin simulator)
5. Margin Requirements Part, rule 2.3 (Review of margin)

2: Definitions and concepts

Margin

2.1 Margin means collateral called and collected by a CCP to cover its current and potential future exposures, as referred to in the Margin Requirements Part, and includes initial margin and variation margin.

2.2 Initial margin means collateral called and collected by a CCP to cover its potential future exposures to clearing members (and, where relevant, to interoperable CCPs) arising in the interval between the last collection of collateral and the liquidation of positions following the default of a clearing member (or, as the case may be, an interoperable CCP).

2.3 Regulatory initial margin means the amounts of collateral calculated by a CCP in accordance with applicable requirements under Chapter 3 of the Margin Requirements Part.

2.4 Lookback period means the time horizon for the calculation of historical volatility.

Margin coverage

2.5 Margin coverage means the extent to which initial margin covers estimated losses.

Margin procyclicality

2.6 Margin procyclicality means the reactivity of initial margin to market volatility.

2.7 Margin procyclicality may cause or exacerbate financial instability by creating additional demand for liquidity during periods of stress. Although initial margin requirements are generally expected to increase during volatile times, initial margin models that are overly responsive to market volatility can act to amplify market liquidity strains by requiring market participants to post significant additional collateral at the CCP to meet their initial margin calls.

Margin cost

2.8 Margin cost means the average initial margin over the financial cycle.

2.9 For example, one measure of margin cost is the average initial margin requirement faced by a clearing member over the financial cycle.

3: The Bank’s expectations regarding a CCP’s management of initial margin procyclicality

Context

3.1 Margin plays a key role in managing counterparty credit risk in centrally cleared markets, including through initial margin, which is sized to cover the potential future losses if either counterparty defaults.

3.2 CCP margin practices became more standardised through global regulatory reforms following on from the 2008 financial crisis. The resulting increase in collateralisation has had significant benefits by reducing counterparty credit risk. However, initial margin is an additional cost for market participants and sudden increases in initial margin requirements due to increased volatility can pose a funding and liquidity risk for participants.

3.3 Market stresses have highlighted potential challenges that margining practices pose, including in centrally cleared markets. Unexpected, procyclical increases in initial margin requirements have previously contributed to funding difficulties in times of stress. This was the case in the March 2020 ‘dash for cash’, where large increases in initial margin requirements driven by increased volatility led some market participants to face liquidity needs materially greater than anticipated – potentially exacerbating liquidity strains for participants.

3.4 A key step towards addressing this challenge is understanding the inherent trade-off – or ‘trilemma’ – between coverage of credit risk, average margin cost, and margin reactivity when setting margin requirements.

Procyclicality assessment framework

3.5 As per rule 3.20 of the Margin Requirements Part, ‘A CCP must identify and define an analytical framework for assessing margin procyclicality within the broader context of margin coverage and margin cost’.

3.6 In addition, rule 3.19 of the Margin Requirements Part states that ‘When a CCP sets the parameters of the model it uses in setting regulatory initial margin and revises those parameters in order to better reflect current market conditions, it must take into account any potential effects of those parameters or their revision on margin coverage, margin cost and margin procyclicality’.

3.7 It would be reductive for a CCP to isolate one aspect of performance, such as margin procyclicality, to monitor that dimension in isolation, and to determine the success or failure of a given model using that single dimension.

3.8 For example, a CCP could consider how decreasing the level of margin procyclicality could have a negative impact on margin coverage (i.e. an increase in the number of potential breaches) and/or on margin cost (e.g. a higher level of margin called to cover the same risk). Analysis of this type could highlight the sensitivity of the model along each of these dimensions, as well as how these sensitivities may increase or decrease depending on a specific set of market conditions.

Figure 1: Illustration of the margin trilemma between coverage, cost and reactivity

The inherent trade-off between margin coverage, reactivity and cost

3.9 A CCP should, in defining its framework for assessing margin procyclicality and as part of the assessment, take into consideration the characteristics of its product offering and its membership (for example, market participants’ liquidity preparedness to meet margin calls, the underlying volatility of the products traded, and the clearing mandate), as well as its risk management practices.

Anti-procyclicality margin measures

3.10 As per the Margin Requirements Part, rule 3.18(1), a CCP must, in order to ensure that its policy for selecting the parameters of its initial margin model limits procyclicality, ‘employ at least one of the following options:

1. apply a buffer at least equal to 25% of the calculated regulatory initial margin other than add-ons for non-market risk or the equivalent set of parameters which it allows to be temporarily exhausted in periods when calculated regulatory initial margin is rising significantly;
2. assign at least 25% weight to stressed observations in the lookback period calculated in accordance with 3.13 – 3.16;
3. ensure that its calculated regulatory initial margin other than add-ons for non-market risk is not lower than that that would be calculated using volatility estimated over a 10-year historical lookback period.’

3.11 A CCP should apply each option (anti-procyclicality (APC) margin measure) it employs to at least all material risk factors that could potentially lead to big-stepped changes in margin, and could include price shifts, foreign exchange shifts, implied volatility shifts, maturity spreads and portfolio margin offsets, as applicable. For the avoidance of doubt, a CCP may apply APC margin measures at a product or portfolio level as long as the application addresses all material risk factors used in the margin computation.

3.12 A CCP that chooses to apply a margin buffer in accordance with rule 3.18(1) for non-linear products, such as options, should apply a buffer at the risk-factor level instead of directly scaling up the margin by 25% of the calculated regulatory initial margin.

3.13 In applying the APC margin measures at the risk factor level, a CCP may use different APC margin measures for different risk factors or apply the same APC margin measure across all risk factors. If a CCP chooses to use the same APC margin measure across all risk factors, it may do so by applying the measure independently to each risk factor or by using internally consistent scenarios across risk factors.

3.14 A CCP employing a margin buffer at least equal to 25% of the calculated regulatory initial margin should develop and maintain documented policies and procedures setting out the circumstances under which the buffer could be temporarily exhausted. Such policies and procedures should specify at least:

1. the metrics and thresholds for which the CCP believes that margin requirements are rising significantly and which may warrant the exhaustion of the margin buffer;
2. the conditions for replenishment of the margin buffer following its exhaustion; and
3. the governance arrangements surrounding approvals for the exhaustion and replenishment of the margin buffer.

3.15 A CCP should not use modelling procedures such as applying different weights to observations within the lookback period to reduce the effectiveness of using a 10-year historical lookback period for the computation of the margin floor when applying the APC margin measure in rule 3.18(3).

3.16 A CCP employing the APC measure in rule 3.18(3) (margin floor) should compute the measure at the same frequency as the regular computation of margin, unless that CCP is otherwise able to demonstrate that the margin floor will remain stable over an extended period of time until the margin floor is re-computed.

Tolerance for margin procyclicality

3.17 As per rule 3.24 of the Margin Requirements Part, ‘The framework referred to in 3.20 must specify: (1) the tolerance for procyclicality of its initial margin’.

3.18 A CCP should include as part of its tolerance for procyclicality a measure of the maximum anticipated change in initial margin, for example over a set period of time, beyond which a CCP should perform a review of its margin framework. This tolerance should not impose a cap on initial margin increases and should not prevent a CCP from achieving adequate coverage. A CCP’s tolerance for procyclicality could be, for example, the maximum percentage change in initial margin over the Margin Period of Risk (MPOR) before a CCP reviews or considers acting to address the performance of its margin model. A CCP may decide to set distinct tolerances for markets with differing risk profiles or to adopt a single tolerance.

3.19 As per rule 3.22 of the Margin Requirements Part, ‘A CCP must inform the Bank of the framework’ for assessing margin procyclicality ‘and its parameter choices’. These include a CCP’s tolerance for procyclicality.

Quantitative metrics used to assess margin procyclicality

3.20 As per rule 3.24 of the Margin Requirements Part, ‘The framework referred to in 3.20 must specify: […] (2) the quantitative metrics a CCP uses to assess the procyclicality of its initial margin’.

3.21 In conducting its assessment, a CCP should holistically assess the long- and short-term stability of its margin, including in comparison to the market volatility using relevant indicators, and the conservativeness of its margin using the metrics it defines. For example, short-term stability could be measured by metrics such as margin changes over a defined period or the standard deviation of margin, and long-term stability could be monitored by metrics such as margin peak-to-trough ratio over a defined period.

3.22 A CCP should take into account any manual overrides (as set out in rules 3.28-3.29 of the Margin Requirements Part) when assessing model performance. Models should be designed to avoid the need for such overrides, but they may be necessary in exceptional cases; where these are necessary, the CCP should also trigger an investigation into how this can be avoided in future, taking into consideration whether the APC risk appetite would have been breached if the override were not used.

Frequency of the assessment

3.23 As per rule 3.24 of the Margin Requirements Part, ‘The framework referred to in 3.20 must specify: […] (3) the frequency at which a CCP conducts the assessment’.

3.24 A CCP should apply the metrics to assess the procyclicality of its margin requirements regularly, including before making any significant revisions to its margin model parameters in order to assess the potential procyclicality arising from such revision.

3.25 A CCP should monitor its models’ performance against its procyclicality tolerance each day in order to evaluate whether there are any breaches. In times of market stress, a CCP should frequently monitor the changes in initial margin and their impact on the quantitative metrics it uses to assess the procyclicality of its margin.

Potential actions

3.26 As per rule 3.24 of the Margin Requirements Part, ‘The framework referred to in 3.20 must specify: […] (4) the potential actions a CCP could take to address the outcomes of the assessment’.

3.27 A CCP should, when its tolerance for procyclicality is exceeded, review its margin model’s performance within the context of the broader trade-off across margin coverage, margin procyclicality and margin cost. This holistic approach can aid with understanding whether the procyclicality trigger was paired with desirable or undesirable outcomes related to cost or coverage.

3.28 A CCP should specify further actions to be taken in case its tolerance is exceeded. These actions should be proportionate to the results of the review and could include internal actions (e.g. escalation) potentially leading to a change in that CCP’s margin model.

3.29 A CCP should document and inform the Bank of the results of any reviews resulting from the assessment of the quantitative metrics and any action taken, in accordance with rules 3.26-3.27 of the Margin Requirements Part, including where the CCP’s tolerance for procyclicality is exceeded.

3.30 If the model revision may be in scope of the approval process, the CCP should follow the rules set out under Chapter 13 of the Review and Testing of Models and Parameters Part. Further guidance on this process is set out in the statement of policy (SoP) on supervisory processes and margin permissions (‘The Bank of England’s approach to supervisory processes (model changes, recognition orders and variations of recognition orders) and margin permissions).

Governance arrangements

3.31 As per rule 3.24 of the Margin Requirements Part, ‘The framework referred to in 3.20 must specify: […] (5) the governance arrangements surrounding the reporting of the outcomes of the assessment and approval of the actions a CCP proposes to take in relation to the outcomes’.

3.32 In line with rule 3.2 of the Review and Testing of Models and Parameters Part, any ‘material revisions or adjustments’ to a CCP’s policies, as set out in rule 3.1 and including policies for testing regulatory initial margin, must be ‘subject to appropriate governance, including seeking advice from the risk committee, and validated by a qualified and independent party prior to application’. This should include any revisions or adjustments to a CCP’s regulatory initial model resulting from an assessment of the model’s procyclical behaviour, in line with rule 3.21 of the Margin Requirements Part, which states that ‘A CCP must use the framework in 3.20 when making governance decisions relating to model reviews’. As set out under rule 3.3 of the Review and Testing of Models and Parameters Part, ‘The validation referred to in 3.1 above must, at least, include the following: […] (3) a review of the parameters and assumptions made in the development of its models, their methodologies and framework’.

4: The Bank’s expectations regarding portfolio margining

4.1 As per the Margin Requirements Part, rule 2.10, ‘A CCP may allow offsets or reductions in margin across the financial instruments that it clears if the price risk of one financial instrument or a set of financial instruments is:

1. significantly and reliably correlated; or
2. based on an equivalent statistical parameter of dependence, with the price risk of other financial instruments.’

4.2 As per rule 2.12, ‘[All financial instruments to which portfolio margining is applied must be covered by the same default fund unless the CCP has first received from the Bank a section 138BA permission permitting the application of portfolio margining to financial instruments covered by different default funds^{footnote [1]}.

4.3 As per rule 2.13, ‘Subject to 2.14, where portfolio margining covers multiple financial instruments, the amount of reductions in margin must be no greater than 80% of the difference between the sum of the margin for each financial instrument calculated on an individual basis and the margin calculated based on a combined estimate of the exposure for the combined portfolio’.

4.4 As per rule 2.14, ‘Where a CCP is not exposed to any potential risk from the reduction in the margin, it may apply a reduction of up to 100% of that difference’.

Different instruments or products

4.5 Where two securities or contracts are considered as the same financial instrument or product following the guidance below (paragraphs 4.10-4.26), a CCP may apply portfolio margining and acknowledge the full amount of offsets derived from its margin model, subject to paragraphs 4.27-4.30.

4.6 Where two contracts are considered as different financial instruments or products following the guidance below, a CCP must apply the cap on the amount of margin offsets prescribed in rule 2.13 of the Margin Requirements Part.

4.7 A CCP should not consider two securities or contracts that are not covered by the same default fund as the same financial instrument or product for the purposes of portfolio margining. However, under rule 2.12 of the Margin Requirements Part, the Bank may give a CCP permission to apply portfolio margining to financial instruments covered by different default funds, as set out in the chapter on margin permissions of the SoP on supervisory processes and margin permissions (‘The Bank of England’s approach to supervisory processes (model changes, recognition orders and variations of recognition orders) and margin permissions’) .

4.8 A CCP should not consider two securities or two contracts in different asset classes as the same financial instrument or product for the purposes of portfolio margining. For this purpose:

1. For securities, relevant asset classes are: i) equities and ii) bonds (including repurchase agreements on bonds).
2. For derivatives, relevant asset classes are: i) Interest Rates; ii) Equity; iii) Credit; iv) FX; v) Commodities

4.9 The following classification should apply to identify different instruments or products. For the following asset classes, the classification specified below should apply for the purpose of the application of rules 2.12-2.13. References to ‘instruments’ should be understood also as references to ‘products’.

Securities

4.10 Securities within the same asset class and issued by the same legal entity may be considered the same financial instrument or product for the purpose of the application of rule 2.13. For example, two bonds issued by the same entity can be considered as the same financial instrument; a bond and an equity issued by the same entity should be considered as different financial instruments.

Derivatives

Interest Rate Derivatives

4.11 Interest rates derivatives having different currencies should be considered different products.

4.12 An interest rate swap and a bond future should be considered different products.

4.13 An interest rate derivative and an inflation derivative should be considered different products.

4.14 Futures referencing bonds issued by different issuers should be considered different products.

4.15 Futures referencing bonds issued by the same issuer may be considered the same product.

4.16 Interest rates swaps of the same currency, but referencing a different index, such as a swap using the Secured Overnight Financing Rate for its floating leg and a swap referencing OIS for its floating leg, may be considered as the same product.

4.17 Interest rates derivatives (swaps, forward rate agreements, and swaptions), with the same currency and the same reference index, but having different maturities, may be considered as the same product.

Equity Derivatives

4.18 Equity derivatives referencing different underlying instruments or indexes should be considered different products.

4.19 Equity derivatives on the same underlying with different strikes or maturities, may be considered as the same product. For example, this may include a future and an option on the same equity.

Credit Derivatives

4.20 Credit derivatives on different underlying names or indexes (including two series of the same index) should be considered different products.

4.21 Credit derivatives on the same underlying name or index with different maturities or coupons, may be considered as the same product.

FX Derivatives

4.22 FX derivatives on different pairs of currencies should be considered different products.

4.23 FX derivatives on the same pairs of currencies with different maturities may be considered as the same product.

Commodity Derivatives

4.24 Commodity derivatives on different underlyings should be considered different products.

4.25 Commodity derivatives on the same underlying with different maturities may be considered as the same products.

4.26 The different underlyings for commodity derivatives are listed in the second column, labelled ‘sub products’ in Table 2 of the Annex of Delegated Regulation EU 2017/585 of 14/07/2016 supplementing Regulation (EU) No 600/2014 of the European Parliament and of the Council.

Situations where a CCP may apply more than 80% of margin reduction

4.27 Rule 2.14 states that ‘Where a CCP is not exposed to any potential risk from the reduction in the margin, it may apply a reduction of up to 100% of that difference’. This only applies in situations where fundamental economic relationships between components of a portfolio result in an absolute limit to the amount of losses that a CCP can suffer.

4.28 Rule 2.14 of the Margin Requirements Part does not apply where there is a limited probability that the losses of the portfolio would go beyond the level of initial margin. The reference to ‘not exposed to any potential risk’ should be considered as the maximum loss that the CCP can experience from a given position, therefore there should be no possibility that the losses of the portfolio would go beyond the level of initial margin. For the avoidance of doubt, this implies that simply relying on back-test results would not be acceptable justification to allow a reduction in margin beyond 80%.

4.29 Examples of when a CCP would be allowed to acknowledge margin reductions in excess of 80% are:

1. A CCP clears a future on an index and futures on each of the constituents of the index, and when no rebalancing of the index is to occur before the expiry of the futures (the timing of such events being known in advance).

2. A portfolio with a long position on the index and a short position of each of the constituents would represent a case where a CCP has no residual risk after the reduction of margin beyond 80% and up to 100% minus the maximum loss.

An account has the following three FX positions: long 1 unit in the pair A-B, long 1 unit in the pair B-C, long 1 unit in the pair C-A; and all three pairs have the same maturity. In this case, the CCP is not exposed to any potential risk due to the arbitrage relationship between the three pairs.

5: The Bank’s expectations regarding the provision of a margin simulation tool

5.1 As set out in rule 5.1 of the Margin Requirements Part, ‘A CCP must provide its clearing members with a simulation tool which allows them to determine the amount of additional regulatory initial margin other than add-ons for non-market risk at portfolio level (on a non-binding basis), that the CCP may require upon the clearing of a new transaction.’

5.2 Rule 5.2 states, ‘A CCP must where requested by clients, prospective clearing members, or prospective clients, provide them with the simulation tool referred to in 5.1.’

5.3 As set out in rule 5.3, ‘A CCP must ensure that the simulation tool referred to in 5.1 covers a number of the CCP’s stress test scenarios, including key historical market stress tests for current and hypothetical portfolios, incorporating the CCP’s main add-on charges that are systematically required across clearing members in addition to the regulatory initial margin indicated by its model, and reflects all material components of the underlying quantitative methodology.’

5.4 The simulation tool should only be accessible on a secured access basis, and the results of the simulation should not be binding. Where necessary, this access may be paired with appropriate non-disclosure agreements.