The role of margin requirements and haircuts in procyclicality
The recommendations address the linkages between margining practices, defined broadly to include the haircuts applicable to funding collateral as well as the mark to market and collateral requirements applicable to OTC derivatives, and financial system procyclicality. The recommendations aim to promote haircuts and initial margin requirements that are more stable across the cycle and calibrated to include periods of stressed market conditions and that thus reduce financial system procyclicality.
The recommendations are the following: (1) linking the credit terms that can be applied to securities financing transactions (SFTs) and OTC derivatives contracts to: (i) the dealers' capacity to mark to market the collateral posted (in the case of SFTs) and the contracts themselves (in the case of OTC derivatives); and (ii) the frequency with which this is done; (2) minimising the risk of breaches of credit triggers used in agreements governing OTC derivatives trades adversely affecting financial market conditions by (i) discourage the use of contractual terms that may generate large, discrete margin calls on counterparties and require that market participants,1 irrespective of their credit rating, be subject to frequent variation margin payments, ideally on a daily basis, when the mark to market losses on derivatives trades exceed moderate threshold amounts; (ii) for all regulated market participants, disallow the use of credit triggers as a factor decreasing the estimated exposure at default (EAD) for determining regulatory capital charges; and (iii) require regulated market participants to have liquidity risk management systems that take appropriate account of various credit trigger-related liquidity shocks; (3) improving the stability of the supply of secured financing through the securities lending programme, developing best practice guidelines for negotiating terms for securities lending, and requiring custodian banks administering such programmes to provide improved disclosure of the risks underlying their reinvestment activities; and (4) consider the value of regularly conducting and disseminating a predominantly qualitative survey of credit terms used in these markets, including haircuts, initial margins, eligible pools of collateral assets, maturities and other terms of financing.
It is also recommended that macroprudential authorities consider: (1) reducing financial system procyclicality resulting from changes in the supply of secured financing driven by market practices for setting haircuts in SFTs by (i) setting capital requirements on securities financing for banks and broker-dealers on the basis of considerations that under normal circumstances are relatively stable through the cycle, and (ii) considering the prudential impacts and practical implications of imposing a countercyclical add-on which can be used by macroprudential authorities to make discretionary changes to capital requirements on secured lending; and (2) reducing financial system procyclicality arising from margining practices in secured lending and derivatives transactions by (i) promoting the use of properly risk-proofed central counterparties (CCPs) that mitigate counterparty risk concerns for clearing standardised derivative instruments and seriously consider the use of such counterparties - among other options - for SFTs, (ii) encouraging supervisors and other relevant authorities to review the policies and risk management practices of central counterparties for possible procyclical impacts related to haircuts and margins, and (iii) considering the prudential impacts and practical implications of imposing, through such CCPs, minimum constant through-the-cycle margins and haircuts, with a possible countercyclical add-on.