Like all financial models, clearinghouse margin executives come under heavy scrutiny from regulators, who keep their eye on the changes the CCP wants to make. Not surprisingly, given that major revisions can have an impact on the smooth functioning and security of markets. But unlike other financial models, those used by PCCs are also watched with the same attention by their members and clients.
This is doubly the case at CMF Group, the world’s largest futures exchange, which is shifting its thousands of contracts to a personalized value-at-risk methodology. The move is causing a stir in the derivatives markets, and it’s no wonder: the introduction of a new margin model still has the potential to create big winners or losers.
CMF said the margins won’t change much with the new framework, but market players are skeptical. Multiple competing interests are at stake: by their own admission, FCMs want margins to remain high to minimize risk and maximize revenue, but on the other hand, favor a more precise model with less operational risk.
Clients generally like to see lower margins to reduce trading costs, and therefore would favor a more responsive model that would give holders of balanced portfolios a more precise reflection of their risk. All the while, others PCCs around the world, 32 of which license the current model, are watching closely.
Span, or Standard Portfolio Risk Analysis, to give it its full name, has been around since the 1980s – and when you consider the stakes of any change, it may not be surprising that Merc has persisted with the same basic approach for over three decades. Eurex, the first major futures exchange, had to move to a VAR-based on a margin model, several years to develop its new framework, obtain the necessary approvals and migrate all its product sets.
Granted, Span had its quirks – but these often served to satisfy market participants: the model’s clumsy approach to setting margins product by product, for example, was seen as overly cautious by market participants – but this often had the effect of maintaining high margins, to the satisfaction of dealers, while for customers and licenses PCCs, this meant that the model was easy to reproduce.
On the other hand, the new VAR This model introduces transparency and is operationally simpler, but could prove to be more complex for less sophisticated actors. Gone are the dozens of settings with the original Span: in their place is a self-calibrating template, which will assess the performance of an entire portfolio under various scenarios.
While the new VAR model at the heart of the framework’s market risk segment is more automatic and apparently less manually driven by the decisions of CMF staff, there are still plenty of knobs for the CMF changes that could affect margins – setting volatility floors, for example, and correlation offsets between product sets.
Depending on where these come out, the stock market could indeed ensure that margins do not fall too much from current levels. But many smaller, less sophisticated buy-side firms that trade on CMF will also want a predictable pattern that they can easily replicate; more moving parts could interfere with this.
CMF should tread carefully among these competing interests – but it should not be afraid to make decisions that bother some of its stakeholders, if taken in the spirit of better risk management. As a major clarifier, the stock market needs to think about its own safety and soundness, not just its bottom line.
CMF, and peers such as LME and Ice, who also build VAR models, will have to keep this in mind: as one main regulator privately put it Risk.net, “All the new models will have to be justified to us”.
Editing by Tom Osborn