Procyclicality of central counterparty margin models: systemic problems need systemic approaches

By definition, the market risk models used to estimate initial margin, whether for centrally cleared or bilaterally cleared trades, have to be sensitive to changes in market risk and, consequently, when market risk increases, initial margin requirements will tend to increase. To mitigate the potential effects of such procyclical behavior, central counterparties have different procyclicality mitigation tools put in place. However, there appeared to be renewed interest in the procyclicality of initial margin models after the market stress of March 2020. In this paper we argue that the focus on initial margin models is misplaced. First, margin calls are largely driven by variation margin, not initial margin. Second, the inherent risk sensitivity of margin models, the stochastic nature of the problem and the different trade-offs involved constrain what can be achieved with model calibration. We illustrate why this is the case by empirically testing the performance of standard initial margin models during the March 2020 events and quantifying the different trade-offs involved. If fragilities in the system therefore persist, how should these be addressed and who is responsible for addressing them? We argue that these questions demand a systemic perspective, focusing on the interactions between participants rather than on a single node.