Margin strategy critical in CCP battle with clearing houses

Bipin Patel: FT letter to the editor

4 Jul 2011

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Margin strategy critical in CCP battle with clearing houses

From Mr Bipin Patel.

Sir, Having read the article "Clearing houses' tactics trigger concern" (June 29), it is important to point out a few facts that determine how clearing houses or central counterparties (CCPs) devise their margin strategies.

Firstly, it is critical to separate CCP margins into variation margin and initial margin. Variation margin is calculated on a trade-by-trade basis and offsets changes in value, whereas initial margin provides default protection and is usually calculated on a portfolio basis to allow for the offsetting of risk.

Secondly, initial margin models greatly differ between the various CCPs even for very similar products, for example, vanilla interest rate swaps. However, we have noted that certain CCPs are in the process of re-evaluating their initial margin model and its effectiveness in capturing risk versus the model's attractiveness to potential clients.

Thirdly, given the complexity of pricing derivatives and the compounded challenges of calculating initial margins, there is no clear-cut solution to measure these risks. As a result, CCPs are in the process of developing margin models which they feel best capture relevant risks and provide adequate levels of protection against counterparty default.

Ultimately, clients will be attracted to using CCPs with initial margin models that require lower levels of margin thereby reducing trading costs.

To make matters worse, CCPs will also have to compete with new and improved bilateral credit support annex (CSA) arrangements which are evolving to promote greater frequency of margin calls and offset of risk along the lines of CCP models.

As CCPs deliberately slash margins to compete with other clearing houses and new CSA arrangements, it may just turn out that they themselves have the most to lose.