Clearing houses should use risk add-ons to ensure margin requirements will be sufficient during stressed market conditions, writes Tore Klevenberg, Partner and CEO, Baymarkets AS.
The United Kingdom is notorious for its unpredictable weather – bright sunshine can give way to pouring rain in minutes, and vice versa, at the height of both summer and winter. Prudent commuters often choose to carry an umbrella or raincoat even when the sun is shining. They might never need them, but they know they have greater control if they take them.
Central counterparty (CCP) risk models work in much the same way – a standard risk model will assess prevailing market conditions and calculate margin requirements for clearing members accordingly. That’s fine if market conditions remain benign, but just as the commuter takes a coat in case it rains, CCPs need to be prepared for when markets turn sour.
This is why it is so important that CCPs employ rigorous risk management practices, including additional risk controls and add-ons, to ensure they can survive volatile markets without having to draw down on member resources to stay afloat. That means topping up collateral supplies to account for specific tail risks based on reliable calculations.
A risk-sensitive margin calculation methodology that operates across asset classes and currencies should be one of the key aspects that underpin a clearing system. Baymarkets’ Clara, for example, uses value-at-risk to measure the risk of loss of a portfolio in normal market conditions over a given period of time, and Monte Carlo simulation of the underlying risk factors to approach the target portfolio distribution.
Recognising the importance of concentration risk and wrong-way risk, two specific add-ons allow CCPs to better manage risk during adverse market conditions.
Concentrated positions in derivatives can be a particular problem in stressed markets because they become more difficult to transfer or close out, and it is therefore prudent to hold additional margin to mitigate concentration risk. A concentration risk add-on can be calculated by CCPs and added to the regular margin requirement.
Meanwhile wrong-way risk can be defined as the correlation between market risk and credit risk of the owner of the portfolio, and can usually be classified as either specific wrong-way risk arising from long exposure in own issued securities, or general wrong-way risk arising from long exposure in either a sector, region or currency where the counterparty is listed.
Concentration risk and wrong-way risk are often increased by the practices of individual firms and the makeup of their portfolios, but additional risk add-ons may be necessary in certain markets. A liquidity risk add-on could be considered important in emerging markets, for example, where liquidity can be very unpredictable and requires CCPs to hold additional margin.
The risk add-ons added to Clara ultimately mean market participants that build up significant risk concentration, or large positions in their own sector, will find themselves having to post larger amounts of collateral. It also means, however, that CCPs can be sure they have sufficient resources to protect themselves come rain or shine.
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