13 Feb 3 Reasons Initial Margin is Unrelated to BASEL III’s Leverage Ratio
APPLES AND ORANGES
BASEL III plans to apply the leverage ratio to all collateral, including initial margin on cleared derivatives transactions (cleared at a clearinghouse). Swap Market participants are looking at cost increases estimated at 60%.
Applying leverage ratio to initial margin means sell side would have to recoup that capital charge by charging their clients more to enter a transaction. The risk that sell-side seek other less expensive, venues on which to trade derivatives.
The leverage ratio is one measure used to calculate the capital requirement of an institution. The goal of capital requirements is to mitigate institutional risk. Including initial margin posted to a CCP as part of an institution’s leverage ratio is expensive. The FIA published a good article on this topic. Allow me to explain 3 reasons why initial margin should not be included in the leverage ratio calculation.
REASON ONE: INCLUDING INITIAL MARGIN IN LEVERAGE RATIO BLURS SEGREGATION OF MARGIN FUNDS
- After MF Global this much is clear: SEGREGATED means SEPARATE. Yes, PHYSICALLY separate. It’s not the institution’s money. You can’t use it. You can’t leverage it. Don’t touch it and leave it alone.
- Being Segregated funds, they add no risk to an institution
REASON TWO: INCLUDING INITIAL MARGIN MAY SKEW RISK REPORTS
- Initial margin is a good faith deposit posted by both counterparties in a derivatives transaction. As mentioned above, those funds are SEGREGATED.
- Any profit or loss beyond the initial margin is paid by the losing side of the trade and received by the winning side of the trade.
- VARIATION MARGIN is NOT segregated.
- Variation margin (daily P&L on the derivative contract) stays within the institution’s risk pool and should be a part of the Leverage Ratio calculation.
- Institutions rely on risk reports to properly hedge their risk/s.
- A risk number which includes Initial Margin could skew hedge activities unless a process to back out the initial margin is done (which is rife with risk potential all its own)
- Including Initial Margin in an institutions leverage ratio will cost the institution money to safeguard client funds in a segregated account.
REASON THREE: RISK MANAGEMENT IS A BALANCING ACT
- Initial margin can be changed by the CCP at any time (intraday or overnight)
- This means initial margin has TWO problems in being included in an institutions leverage ratio:
- If the Initial margin is increased, more collateral will be collected from both parties and more capital charges due to the higher leverage ratio.
- Initial Margin, as a segregated good faith deposit, mitigates risk. It stands separate from the leverage ratio. In fact, Initial Margin can be increased if the derivative’s underlying asset becomes more volatile. In this sense, it provides an institution more protection.
- Including Initial Margin in the leverage ratio calculation will double count the risk due to the risk mitigation process already applied to initial margin.
SUMMARY & CONCLUSION
Regulators want to mitigate as much risk as possible. As a rule of thumb, Initial Margin covers three times the average daily move. Said another way, Initial Margin covers a 3 standard deviation move. 3 Standard deviations take into account 299 of 300 occurrences.
The Dow Jones chart below shows 10 events greater than 5 STDEV since 1997. That’s 10 events in roughly 3900 occurrences. Statistically, a 5 standard deviation event has a probability of once every 1.8 million occurrences. Because the exchange can raise initial margin if the asset becomes more volatile, there’s no need to require additional capital charges. While the increase in volatility indicates a greater leverage ratio, the leverage ratio is covered by raising initial margin.
SUMMARY & CONCLUSION
J.P. Morgan did a good business unit level piece. It’s perhaps more than one wants to know about this issue, at 20 pages it’s a long piece. But it includes the calculations and some great matrices (cheat sheets) in the appendices.