The report was written by Daniel Heller and Nicholas Vause on behalf of the Monetary and Economic Department of the Bank for International Settlements (BIS).
The paper estimates the amount of collateral that CCPs should demand to clear safely all interest rate swap and credit default swap positions of the major derivatives dealers. The results suggest that "major dealers already have sufficient unencumbered assets to meet initial margin requirements, but that some of them may need to increase their cash holdings to meet variation margin calls." Default funds worth only a fraction of dealer equity "appear sufficient to protect CCPs against almost all possible losses that could arise from the default of one or more dealers, especially if initial margin requirements take into account the tail risks and time variation in risk of cleared portfolios."
Among the conclusions from the study:
- Variation margin calls on G14 dealers from CCPs that cleared all of their IRS or CDS positions could cumulate over a few weeks to a substantial proportion of their current cash holdings, especially under high market volatility.
- Initial margin requirements of CCPs that cleared all of G14 dealers’ IRS or CDS positions would only amount to a small proportion of the dealers’ unencumbered assets.
- The total amount by which initial margins could occasionally fall short of losses on G14 dealers’ IRS and CDS portfolios, if these were comprehensively cleared by CCPs, is significantly greater for the CDS portfolios than the IRS portfolios.
- CCP default funds may need to be about 50% larger to cover losses that could arise from default of the two most important IRS or CDS dealers rather than the single most important dealer.
- Total collateral requirements for comprehensive central clearing of G14 dealers’ IRS and CDS positions depends significantly on the market structure under which it might take place. For example, if a single CCP were to clear all CDS, this would require roughly 25% less collateral for variation margins, initial margins and default fund contributions than three regionally-focussed CDS CCPs. Similarly, if a single CCP were to clear all multi-name and single-name CDS, this would cut collateral requirements by around 50% compared with two CCPs specialising in each product.
- If CCPs that cleared all G14 dealers’ positions in IRS or CDS varied initial margin requirements over time with the volatility of IRS and CDS market values, rather than keeping them fixed, risk to default funds would be reduced substantially.
- Risk to default funds would be much greater relative to initial margins for comprehensive clearing of G14 dealers’ CDS portfolios than for their IRS portfolios.