Regulating Margin Requirements and Haircuts By David Longworth, Adjunct Research Professor Adjunct Research Professor Carleton University 1
Background: Financial Crisis Background: Financial Crisis • Increased leverage in financial markets in run ‐ Increased leverage in financial markets in run up to crisis – Increase availability of secured financing – Increase availability of secured financing – Rising volume of trading in OTC derivatives – Easing of credit terms, including lower haircuts Easing of credit terms including lower haircuts – Broadening of range of assets used as collateral • Opposites of these happened during crisis O i f h h d d i i i • ‘’Margin spiral’’ 2
Background: Margin Spiral Background: Margin Spiral Less market making Lower Funding market problems liquidity Higher margins Losses on existing positions positions Adopted from Brunnermeier & Pederson (2009) and 3 presentations by Mark Carney and David Longworth
Outline Outline 1 Background 1. Background – CGFS Study, Procylicality 2 Market failure in this area 2. Market failure in this area 3. Some definitions 4. Policies dealing with market failures 5. Complementing other policies p g p 6. What’s to be done to implement policies 7 Concluding remarks 7. Concluding remarks 4
Background: CGFS Study Background: CGFS Study • 2009 CGFS Report identified this broad area as 2009 CGFS Report identified this broad area as one source of procyclicality • To follow up CGFS asked a Study Group which • To follow up, CGFS asked a Study Group, which I chaired to explore options for reducing this source of procyclicality source of procyclicality 5
Background: Procyclicality Background: Procyclicality Cycle Risk Macroprudential Instrument Credit Cycle Credit Risk Capital Requirements Leverage Requirements Liquidity Cycle Liquidity Risk Liquidity Requirements Financial Asset Price Cycle Market Risk Margin & Haircut Requirements Collateral Risk Property Price Cycle p y y Collateral Risk Loan ‐ to ‐ value Restrictions (& other mortgage restrictions) 6
Market Failures Market Failures • Procyclical nature of practices for setting Procyclical nature of practices for setting haircuts and initial margins points to a market failure due to negative externalities associated failure due to negative externalities associated with the setting of credit terms – Collective actions of what is reasonable behaviour – Collective actions of what is reasonable behaviour at the individual level allow for the occurrence of bad outcomes for the system as a whole y 7
Securities Financing Transactions and OCT Derivatives • Securities Financing Transactions: g – Repo: A contract in which the seller of securities agrees to buy them back at a specified time and price; the contract specifies the haircut the contract specifies the haircut – Securities lending: The lending of securities by one party to another, with the borrower providing the lender with collateral in the form of cash or other lender with collateral in the form of cash or other collateral securities; fee paid, quoted as annualized percentage • OTC Derivatives Transaction An over the counter • OTC Derivatives Transaction: An over ‐ the ‐ counter derivatives transaction, specifying all the margin requirements (initial margin, variation margin) 8
Dealing with Market Failures Dealing with Market Failures • CGFS Report had three types of CGFS Report had three types of recommendations: – Two recommendations dealing directly with – Two recommendations dealing directly with procyclicality – Three recommendations dealing with unhelpful Three recommendations dealing with unhelpful practices that could be procyclical – One recommendation dealing with information One recommendation dealing with information 9
Dealing with Market Failures Dealing with Market Failures • Dealing directly with procyclicality Dealing directly with procyclicality – Set capital requirements on securities financing on the basis of considerations that are relatively stable through the cycle • Consider counter ‐ cyclical add ‐ on by macroprudential authorities authorities – Promote risk ‐ proofed central counterparties that would be constrained in any procyclical behaviour • Consider imposing minimum constant through ‐ the ‐ cycle margins and haircuts, with possible countercylical add ‐ on add on 10
Dealing with Market Failures Dealing with Market Failures Holding capital against exposures (repo etc ) Holding capital against exposures (repo, etc.) • Currently, “a supervisory haircut is set for each transaction secured by eligible collateral ” transaction secured by eligible collateral. – When the haircut charged is less that the supervisory haircut, the difference is treated as an supervisory haircut the difference is treated as an unsecured exposure to the counterparty, and subject to a capital charge. subject to a capital charge. – Supervisory haircuts may be calculated using an approved model, or be taken from a list of pp , standard regulatory haircuts. 11
Dealing with Market Failures Dealing with Market Failures Recommendation Repo Securities Lending OTC Derivatives Set SFT capital √ √ requirements that are relatively stable through the cycle, th h th l with countercyclical add ‐ on (4.2) Promote central Promote central √ √ √ √ √ √ counterparties; minimum constant through ‐ the ‐ cycle margins and haircuts for CCPs; countercyclical add ‐ on (4.4) on (4.4) 12
Dealing with Market Failures Dealing with Market Failures • Three recommendations affecting market Three recommendations affecting market practices that can be procyclical – Link credit terms charged by dealers to dealers’ – Link credit terms charged by dealers to dealers capacity to market to market the collateral posted or the value of the contracts – Discourage the use of contractual terms that may generate large, discrete margin calls – Develop best practice guidelines for negotiating terms for securities lending 13
Dealing with Market Failures Dealing with Market Failures Recommendation Repo Securities Lending OTC Derivatives Link credit terms √ √ √ that can be applied to dealer’s capacity t to mark to market k t k t (4.1) Discourage and √ dampen effects of dampen effects of credit triggers (4.3) Develop best √ practice guidelines p g (4.5) 14
Complementing other policies Complementing other policies Central bank higher liquidity Less liquidity liquidity requirements in requirements in provision market normal times making Lower Central Central Funding market counterparties problems for repo and liquidity OTC derivatives Higher Regulations on margins margins and haircuts Standardization of Losses on securitization existing positions positions Adopted from Brunnermeier & Pederson (2009) and presentations by Mark Carney and David Longworth 15
What’s to be done Internationally What s to be done Internationally • Report has gone to the Financial Stability Board Report has gone to the Financial Stability Board – Will be considered as part of procyclicality agenda • How to deal with each type of recommendation: • How to deal with each type of recommendation: Basel Committee for banks, IOSCO for securities dealers, domestic macroprudential authorities for dealers, domestic macroprudential authorities for levels and for countercyclical add ‐ ons, domestic authorities for ensuring process for best practices g p p in securities lending 16
What’s to be done domestically What s to be done domestically • Canadian authorities should encourage international discussion and agreement, and soon • Where no international agreement on acting, should attempt to get agreement on international attempt to get agreement on international enforcement by currency of denomination of rules set by the domestic authorities in that currency • This would enable almost all recommendations to be • This would enable almost all recommendations to be implemented domestically • Even in absence of such an agreement by currency, most of the recommendations (although not the most most of the recommendations (although not the most important ones) can and should be implemented domestically 17
Concluding Remarks Concluding Remarks • The market failure in the setting of margin The market failure in the setting of margin requirements and haircuts led to an exacerbation of both the boom and bust exacerbation of both the boom and bust • Setting capital requirements so as to favour constant through the cycle haircuts and constant through ‐ the ‐ cycle haircuts and margins should be pursued • As well, macroprudential authorities should A ll d i l h i i h ld be given the right to raise haircuts during b boom periods i d 18
Recommend
More recommend
