March 15, 2022

Cyclical Effects of CCPs in a Stressed Market

A team at the Bank of England conducted a study into Cyclical Effects of CCPs to examine the effects and relationships between CCP margin calls and the Repo market in stressed markets.

A team at the Bank of England conducted a study into the Cyclical Effects of CCPs to examine the effects and relationships between CCP margin calls and the Repo market in stressed markets.

Their introduction:

Using supervisory data from UK central counterparties (CCPs), we study a collateral cycle in which market participants raise liquidity in the repo markets to meet CCPs margin calls, before CCPs reinvest the liquidity through reverse repos as well as bond purchases. In the first leg, we find that increases in the cost of repo funding precede increases in CCP cash margin as market participants anticipate increased margin requirements. However, this effect is moderated by the return leg, where cash margin received by CCPs is returned to market participants via the repo and bond markets. The additional cash being recycled by CCPs via the repo markets alongside the increased demand for safe bonds, create counter‑cyclical effects that lower repo rates, especially at times of stress.

One of their findings is:

Using supervisory data from UK CCPs, we find that every 1% increase in the repo rate is followed by a next-day average increase of £0.38 billion in cash IM, across UK CCPs, but this number increases to around £2 – £5 billion during times of stress such as the Covid pandemic.

Research points covered by the BoE team include:

  • Whether initial margins are procyclical with respect to repo rates (i.e. whether initial margins and repo rates covary positively).

  • How the cash collateral received by CCPs is invested and what impact these investments have on repo markets

  • How CCP investments and the resulting cash collateral cycle affect short-term repo rates

The paper uses data from LCH and ICE to underpin the research, the conclusions begin in section 6 including:

  • This suggests that CCP cash margin is procyclical with respect to secured funding costs and is consistent with clearing members hoarding liquidity in order to meet their CCP margin requests. This link, which establishes a positive relationship between repo rates and initial margin calls, is the first leg of the cash collateral cycle
  • It thus appears that current CCP investment policies are counter-cyclical, mitigating to some extent the procyclicality of their initial margin calls
  • On the other hand, CCPs are only able to return their cash collateral to the market if it is not needed to cover losses from a potential default of a clearing member, which is more likely to materialize in highly stressed periods. Thus, to the extent that market participants depend on CCP cash injections, during these periods, the cash collateral cycle documented in this paper could also turn into a cash collateral spiral if the CCPs are not able to reinvest liquidity collected from market participants. Although an extreme scenario, this potential systemic adverse scenario deserves further research and reflection by policy makers.

The full paper can be found here: Margin procyclicality and the collateral cycle



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