Regulating Margin Requirements and Haircuts - By David Longworth, Adjunct Research Professor Carleton University
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Regulating Margin Requirements
and Haircuts
By David Longworth,
Adjunct Research Professor
Carleton University
1Background: Financial Crisis
• Increased leverage in financial markets in run‐
run
up to crisis
– Increase availability of secured financing
– Rising volume of trading in OTC derivatives
– Easing of credit terms
terms, including lower haircuts
– Broadening of range of assets used as collateral
• Opposites
O i off these
h h
happened
ddduring
i crisis
ii
• ‘’Margin spiral’’
2Background: Margin Spiral
Less
market
making
Lower
Funding market
problems liquidity
Higher
margins
Losses on
existing
positions
Adopted from Brunnermeier & Pederson (2009) and
presentations by Mark Carney and David Longworth 3Outline
1 Background
1.
– CGFS Study, Procylicality
2.
2 Market failure in this area
3. Some definitions
4. Policies dealing with market failures
5. Complementing
p g other p
policies
6. What’s to be done to implement policies
7
7. Concluding remarks
4Background: CGFS Study
• 2009 CGFS Report identified this broad area as
one source of procyclicality
• To follow up,
up CGFS asked a Study Group
Group, which
I chaired to explore options for reducing this
source of procyclicality
5Background: 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
p y Price Cycle
y Collateral Risk Loan‐to‐value Restrictions
(& other mortgage restrictions)
6Market Failures
• Procyclical nature of practices for setting
haircuts and initial margins points to a market
failure due to negative externalities associated
with the setting of credit terms
– Collective actions of what is reasonable behaviour
at the individual level allow for the occurrence of
bad outcomes for the system
y as a whole
7Securities Financing Transactions and
OCT Derivatives
• Securities Financingg Transactions:
– 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
– 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
collateral securities; fee paid, quoted as annualized
percentage
• OTC Derivatives Transaction:
Transaction An over‐the‐counter
over the counter
derivatives transaction, specifying all the margin
requirements (initial margin, variation margin)
8Dealing with Market Failures
• CGFS Report had three types of
recommendations:
– Two recommendations dealing directly with
procyclicality
– Three recommendations dealing with unhelpful
practices that could be procyclical
– One recommendation dealing with information
9Dealing with Market Failures
• 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
– 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
10Dealing with Market Failures
Holding capital against exposures (repo
(repo, etc.)
etc )
• Currently, “a supervisory haircut is set for each
transaction secured by eligible collateral
collateral.”
– When the haircut charged is less that the
supervisory haircut
haircut, the difference is treated as an
unsecured exposure to the counterparty, and
subject to a capital charge.
– Supervisory haircuts may be calculated using an
approved
pp model,, or be taken from a list of
standard regulatory haircuts.
11Dealing with Market Failures
Recommendation Repo Securities Lending OTC Derivatives
Set SFT capital √ √
requirements that
are relatively stable
th
throughh th
the cycle,
l
with countercyclical
add‐on (4.2)
Promote central √ √ √
counterparties;
minimum constant
through‐the‐cycle
margins and
haircuts for CCPs;
countercyclical add‐
on (4.4)
12Dealing with Market Failures
• Three recommendations affecting market
practices that can be procyclical
– Link credit terms charged by dealers to dealers
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
13Dealing with Market Failures
Recommendation Repo Securities Lending OTC Derivatives
Link credit terms √ √ √
that can be applied
to dealer’s capacity
t markk to
to t market
k t
(4.1)
Discourage and √
dampen effects of
credit triggers (4.3)
Develop best √
practice gguidelines
p
(4.5)
14Complementing other policies
higher liquidity Central bank
requirements in Less liquidity
normal times market provision
making
Central Lower
counterparties Funding market
for repo and problems liquidity
OTC
derivatives
Higher Regulations
on margins
margins and haircuts
Standardization of
securitization Losses on
existing
positions
Adopted from Brunnermeier & Pederson (2009) and
presentations by Mark Carney and David Longworth 15What’ss to be done Internationally
What
• Report has gone to the Financial Stability Board
– Will be considered as part of procyclicality agenda
• How to deal with each type of recommendation:
Basel Committee for banks, IOSCO for securities
dealers, domestic macroprudential authorities for
levels and for countercyclical add‐ons, domestic
authorities for ensuringg p
process for best p
practices
in securities lending
16What’ss to be done domestically
What
• Canadian authorities should encourage international
discussion and agreement, and soon
• Where no international agreement on acting, should
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
implemented domestically
• Even in absence of such an agreement by currency,
most of the recommendations (although not the most
important ones) can and should be implemented
domestically
17Concluding Remarks
• The market failure in the setting of margin
requirements and haircuts led to an
exacerbation of both the boom and bust
• Setting capital requirements so as to favour
constant through‐the‐cycle
through the cycle haircuts and
margins should be pursued
• As
A well,
ll macroprudential
d i l authorities
h i i should
h ld
be given the right to raise haircuts during
b
boom periods
i d
18References
• Brunnermeier, Markus K. and L.H. Pederson. 2009. “Market Liquidity and Funding Liquidity,”
R i off Financial
Review Fi i l Studies
S di 22(6):
22(6) 2201
2201‐2238.
2238
• Committee on the Global Financial System. 2009. “The role of valuation and leverage in
procyclicality,” CGFS Papers No 34.
• Committee on the Global Financial System.
y 2010a. “The role of margin
g requirements
q and
haircuts in procyclicality,” CGFS Papers No 36.
• Committee on the Global Financial System. 2010. “Macroprudential instruments and
frameworks: A stocktaking of issues and experiences,” CGFS Papers No 39.
• Dreff Nadja.
Dreff, Nadja 2010.
2010 “The
The Role of Securities Lending in Market Liquidity
Liquidity,” Bank of Canada
Financial System Review, June, 41‐45.
• G20 Working Group 1. 2009. “Enhancing Sound Regulation and Strengthening Transparency,”
Final Report, March 25.
• Kamhi, Nadja. 2009. “Procyclicality and Margin Requirements,” Bank of Canada Financial
System Review, June, 55‐57.
• Turner, Philip. 2010. “Macroprudential Policies and the Cycle,” The Financial Stability Board:
An Effective Fourth Pillar of Global Economic Governance?, The Centre for International
Governance Innovation.
• Whittall, Christopher. 2010. “Margin for error,” Risk, 5:30‐32.
19Background: Margin Spiral
Less
market
making
Lower
Funding market
problems liquidity
Higher
margins
Losses on
existing
positions
Adopted from Brunnermeier & Pederson
20Discussion
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