“There's always an opportunity with crisis. Just as it forces an individual to look inside himself, it forces a company to re-examine its policies and practices.”
This well-known quote from Judy Smith is equally applicable to financial market regulators. Following unprecedented volatility in the spring of 2020, and subsequent liquidity pressures on the market, the European Securities Markets Authority (ESMA) has taken the initiative to evaluate how its anti-procyclicality (APC) measures for central counterparties (CCPs) performed during the stress events.
Although EU CCPs have shown relatively good resilience, ESMA will analyse what lessons can be learned from the crisis in 2020 and how its APC measures may be developed to further enhance CCPs’ resilience in handling potential future stress events.
One year after the Covid-19 outbreak, financial market turmoil and high volatility are well-documented in various research and industry papers. The sharp and extreme market movements in March and April last year were unprecedented in the sense that high volatility was seen across the majority of asset classes. In several cases, the movements were more severe than those experienced during the peak of the 2008 credit crisis. CCPs had to operate their systems and risk management function in these stressed conditions under remote working conditions, sometimes with up to 100 percent of staff working from home.
In this turmoil, CCPs were able to operate without significant disruptions. This success, in my opinion, is a tribute to the regulatory and supervisory efforts of the past 10 years. Since the global financial crisis, international standards for CCPs became more stringent, as evidenced in the CPSS-IOSCO Principles for Financial Market Infrastructures (PFMI).
For example, the PFMI set high standards for the CCPs’ management of legal, credit, liquidity, and operational risks. In addition, requirements for CCP governance were upgraded. These enhanced standards aim to increase the overall resilience of CCPs. Jurisdictions around the world adopted these standards in national legislation, which for the European Union resulted in the European Markets and Infrastructure Regulation (EMIR) and related technical standards.
From a macroprudential perspective, one can say that, generally, the structural risks related to CCPs were well contained. Macroprudential policy distinguishes structural and cyclical risks as drivers of systemic externalities. Structural risks for CCPs would then relate to their central position in financial markets, where they concentrate credit and liquidity risks.
Despite increased market volatility and operational risks, CCPs remained resilient through the crisis. They supported the functioning of financial markets, including the central management of risks, and as such strengthened market confidence and financial stability.
The cyclical risks of CCPs deserve further attention, however. These relate to the possible procyclical nature of margin calls and related risk-management practices of CCPs. CCPs’ margin calls put pressure on the availability of clearing members’ liquid resources and act as macro-financial feedback mechanisms, potentially amplifying adverse aggregate shocks. Indeed, during the Covid-19 crisis, we saw that the increase in margin calls, both in size and frequency, increased the demand for high-quality liquid assets, impacting clearing members, their clients, and the functioning of markets in general.
The PFMI acknowledge the risk of procyclicality of haircuts (Principle 5) and margin calls (Principle 6) and state that CCPs’ initial margin models should “to the extent practicable and prudent, limit the need for destabilising, procyclical changes”. Different jurisdictions have translated this in different ways into their national regulation.
Initial margin models
EMIR contains specific requirements for CCPs to adopt APC tools in their margin models. Even more, ESMA as a regulator has developed a relatively comprehensive and prescriptive framework in comparison with other jurisdictions. It has defined three types of possible APC measures for initial margin models for CCPs to apply:
- Building a buffer: applying a margin buffer at least equal to 25% of the calculated margins, which is to be temporarily exhausted during periods when calculated margin requirements are rising significantly.
- Weighting stress: assigning at least 25% weight to stressed observations in the lookback period.
- Placing a floor: ensuring that margin requirements are not lower than those that would be calculated using volatility estimated over a 10-year historical lookback period.
EU CCPs should deploy at least one of these measures to avoid disruptive or big-step changes in margin requirements and reflect their APC measures in transparent and predictable procedures. In practice, CCPs select one or more of these APC measures, taking into account the specific features of the products and markets they clear. The implementation of different models avoids the potential for systemic “model risk” that could occur if all CCPs adopted the same APC tool, increasing the possibility that specific flaws are exacerbated during a crisis.
The implementation of these APC measures has helped CCPs to mitigate to a certain extent the need for sharp big-step margin changes during the Covid-19 outbreak. However, despite the relatively good performance of EU CCPs, there may be room for further improvements.
ESMA has launched a review of the APC measures adopted by EU CCPs to analyse what can be improved. It has taken on this responsibility under ESMA’s new structure, in close coordination with national competent authorities for CCPs in the EU. The text box below further sets out ESMA’s increased responsibilities for CCPs, including the role of the CCP Supervisory Committee, following the review of EMIR in December 2019.
As a first step, ESMA organised a workshop on APC in February 2021. The workshop enabled representatives from industry and authorities to discuss the performance of APC measures during the crisis and possible ways forward. The level of participation was impressive, showing the overwhelming interest of different stakeholders in this topic. An important finding was that the need for CCPs to call for margin as a protective measure during stress periods was widely accepted.
There are many dimensions to consider in further developing APC measures. For example, to what extent can initial margin models be made anti-procyclical, while staying efficient? What would be a set of metrics to assess the performance of APC measures? How could past stress observations (or potential future scenarios) be used for the purpose of improving the APC tools? How could CCPs more actively review and assess the performance of their tools on an ongoing basis? But also: Is this only a question for CCPs and their regulators, or for the broader ecosystem? Our findings may support international efforts to evaluate the efficiency of anti-procyclicality tools and their implications on liquidity in times of crisis.
We plan to continue our engagements with stakeholders, in coordination with the relevant EU institutions and national authorities, to decide on the next chapter for effective and efficient APC measures.
New responsibilities for ESMA under EMIR 2.2.
The views, thoughts and opinions contained in this Focus article belong solely to the author and do not necessarily reflect the WFE’s policy position on the issue, or the WFE’s views or opinions.