Lessons learned from initial margin calls during the March 2020 market turmoil

Prepared by Thomas Carraro, Linda Fache Rousová, Oana Furtuna, Maddalena Ghio, Kristina Kallage, Charles O’Donnell, Francesco Vacirca and Sebastiano Michele Zema

Published as part of the Financial Stability Review, November 2021.

Margin requirements on derivatives portfolios increased significantly in March 2020, exacerbating liquidity stress as entities took action to meet margin demands. In particular, some non-bank financial entities met margin calls by redeeming shares in money market funds, selling bonds or borrowing in repo markets.^[1] Extraordinary interventions by public authorities were ultimately crucial in stemming stress in these markets.^[2] While margin consists of two main components – initial margin and variation margin – this box focuses on initial margin (IM), since it is subject to model risk and depends heavily on the calibration choices of central counterparties (CCPs) (for centrally cleared transactions) or counterparties (for non-centrally cleared transactions).^[3] As IMs are calibrated to reflect possible future changes in market prices, they are sensitive to market volatility. However, if IMs are overly procyclical (too low in good times and/or too high in bad times), their movements can amplify liquidity stress and lead to selling pressures in financial markets.

The increase in IM amid the March 2020 turmoil was concentrated almost entirely in centrally cleared derivatives and driven mainly by equity, credit and interest rate portfolios (see Chart A, panel b). Between 31 January and 20 March 2020, CCPs collected roughly €30 billion of additional IM from euro area clearing members (a 32% increase), who largely met this by collecting IM from their clients (€23 billion; a 55% increase), most notably from investment funds (€14 billion).^[4] The IM remained elevated throughout the rest of 2020 as – among other factors – the high volatility from the turmoil continued to feed into CCP models over an extended period of time. For non-centrally cleared derivatives, IM remained broadly unchanged, likely reflecting design features of the underlying margin model – the standard initial margin model (SIMM) – which is less responsive to short-term fluctuations in market volatility.^[5]

Analysis of portfolios of centrally cleared interest rate and credit derivatives suggests that CCP model sensitivity to market volatility was the main driver of the increase in IM. In addition to model sensitivity to market volatility, the increase in IM may also reflect portfolio repositioning by investors, motivated by factors like changes in risk appetite and hedging needs. The IM increase is decomposed into the impact from market volatility and repositioning by comparing static portfolios with those where repositioning took place (see Chart B).^[6] For both types of derivative, the results suggest that the increase in IM was mostly driven by model sensitivity to the rise in market volatility. While portfolio repositioning contained the IM increase for interest rate derivatives, it worked in the opposite direction for credit derivatives, reflecting the increased activity in the credit default swap market.

The IM developments of March 2020 suggest that it is important to develop a clearer understanding of the models which CCPs use to calibrate IMs and possibly review such models. This would also be welcomed by some market participants, who would prefer higher margin levels in good times to help reduce the risk of unexpected large margin calls in bad times. Any recalibration should build on a common understanding of “excessive procyclicality”, a concept that would determine when margin calls should be considered too large because they could result in significant repercussions for systemic liquidity. Such a “macro” concept would provide guidance for recalibrating IM models on a “micro” level and also facilitate comparisons of the different models used by CCPs. To increase the resilience of the financial system to liquidity shocks, it would also be important to enhance the transparency of IM models in both centrally and non-centrally cleared markets. The supervisory and regulatory framework governing the liquidity management of market participants, and in particular that of some non-bank financial intermediaries, should also be strengthened (see Section 5.2).