## wp18228

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### Introduction and purpose
- Regulatory attention to over-the-counter (OTC) derivatives increased markedly since the financial crisis of 2008.
- Key post-crisis initiatives cited:
  - Group of Twenty direction that all standardized OTC derivatives should be cleared through CCPs, and that non-centrally-cleared derivatives should be subject to margin requirements (G-20, 2009; G-20, 2011).
  - Basel III liquidity coverage obligations (BCBS, 2015) identified as especially significant for clearing members in stress.
- Objective: assess the impact of prudential regulation on non-defaulting clearing members following a major default among their peer group, with particular attention to liquidity coverage requirements and collateral demand.

### CCP waterfall, margin types, and liquidity concept
- CCP loss-absorption resources ("waterfall") include:
  - Initial margin.
  - “Skin-in-the-game” (CCP-held resources).
  - Default fund (mutualized resources provided by clearing members).
  - Capital (owners’ investment in the CCP).
  - Contingency arrangements for loss-allocation at the end of the waterfall.
- Distinction between margin types:
  - Initial margin: provided to cover potential future losses during the margin period of risk; typically exchanged at inception and may be adjusted.
  - Variation margin: provided and adjusted more frequently to reflect changes in contract value.
- Liquidity in stress includes both cash and collateral (HQLA); these can be used interchangeably by financial institutions to meet liquidity needs.

### Scope and framing of the stress scenario
- Scenario: a major clearing member defaults and the entire CCP waterfall is exposed, so that loss-allocation arrangements may come into play.
- The paper assumes end-of-waterfall scenarios would arise only in highly unusual circumstances and does not re-open debate on adequacy of CCP resources.
- Analysis focuses on collateral needs during stress and interaction between CCP recovery tools and prudential regulation.

### CCP default-management tools and plausible outcomes
- CCP actions and outcomes:
  - Auction and transfer to re-establish a matched book; success depends on realistic bids.
  - Failed auction risks exhausting the CCP’s default waterfall; alternatives include tear-up of positions or haircutting variation margin gains (VMGH).
  - End-of-waterfall scenarios considered realistic by some studies (Lin and Surti, 2013; Paddrik and Young, 2017; Capponi et al., 2018).
- Relevant scale examples:
  - Gross notional (open interest) for LCH (SwapClear operator): US$164 trillion versus resources immediately available for a typical SwapClear clearing member: US$11.65 billion.
  - Comparable figures for CME: US$16 trillion and US$5.78 billion.
- VMGH (variation margin gains haircutting):
  - Mechanic: CCP withholds variation margin due to in-the-money non-defaulting members, supplying CCP with cash for default management; gainers irrevocably lose their gains while out-of-the-money losers continue to pay.
  - Scenario assumption: LCH implements VMGH; no other CCPs do.
- Clearing members as service providers:
  - “Pay-as-paid” clauses typically enable clearing members to pass losses on client positions to clients; prudential derogations may apply (cf Regulation (EU) 575/2013, Article 306).

### Uncleared portfolios and post-default impairment
- Close-out of transactions with the defaulter may be impaired if market liquidity is dysfunctional; collateral liquidation may not realize values.
- A non-performing uncleared portfolio accrues market risk without variation margin inflows — functionally similar to VMGH on cleared portfolios.
- Surviving bilateral activity with other non-defaulters likely to see:
  - Increases in initial margin obligations on both sides.
  - Haircut increases reflecting impaired collateral values and fire-sale pressures.
  - Revaluation effects where credit values influence transaction valuations, raising potential future exposure and requiring additional margin.

### Prudential regulation channels affecting surviving clearing members
- Regulatory incentives favor clearing; mandatory clearing attracts special prudential treatment.
- Eight prudential metrics could affect cleared business; examples:
  - Moderately affected metrics: capital requirements for counterparty risk, leverage ratio.
  - More substantially affected metrics: VMGH increases position risk capital charges; Liquidity Coverage Ratio (LCR) is the most significant channel affecting HQLA demand.
- Specific LCR impacts post-default:
  - Default fund utilization or expected utilization creates a 30-day replenishment outflow that must be expected and covered by HQLA.
  - Basel III obliges collateral-providers to retain HQLA of 20 percent of the value of initial margin posted where posted collateral is not “level 1” assets (BCBS, 2013, paragraph 119).
    - Effect stated: each margin hike has a real impact of more than 100 percent of the additional margin called when collateral is not level 1.
  - VMGH reduces expected future cash inflows (variation margin) and those inflows cannot be counted when assessing liquidity; clearing members must evaluate duration of VMGH up to 30 days and cover reduced inflows with HQLA.
- Example figures:
  - LCH 2018 data: top 10 clearing members contribute on average 3.1 percent of the default fund.
  - Capital requirement uplift for a surviving clearing member from loss of its contribution is probably limited to about 10 percent, or US$1.7 million.
  - Basel III does not treat a CCP as an impaired credit after default-fund utilization; CCP trouble does not automatically translate into capital adequacy hits for clearing members as CCP creditors.
- Uncleared business differences:
  - New regulation requires initial margin for uncleared trades provided as HQLA, with gross, non-rehypothecatable transfers and a 10-day margin period of risk (BCBS, 2015).
  - Re-evaluation of collateral amounts in stressed markets will likely increase initial margin obligations for uncleared trades.

### Immediate simultaneous HQLA demands in stress (items and magnitudes)
- Surviving clearing members likely face simultaneous HQLA demands:
  - Backing expected CCP default-fund replenishment demands dollar-for-dollar with HQLA while awaiting formal calls.
  - Initial margin hikes impose HQLA requirements, scaled up by an additional 20 percent for collateral that is not “level 1” due to LCR effects.
  - Expected variation margin receivable from cleared and uncleared defaulted portfolios may not be received (VMGH for cleared; zombie portfolios for uncleared), reducing cash inflows and necessitating higher HQLA holdings.
- Quantified IMF staff estimates and scenario items:
  - Default fund utilization (single full replenishment for four CCPs: LCH, CME, ICE, Eurex): approximately US$22 billion (Khwaja, 2018).
  - LCH default fund: US$6.7 billion.
  - Total commitments by clearing members across CCPs: approximately US$75 billion (Khwaja, 2018).
  - Initial margins posted to CCPs are estimated to be US$500 billion.
  - Initial margin posted for cleared interest rate and credit derivatives: US$194 billion.
  - If surviving clearing members worldwide experience another average 5 percent hike, haircut-related initial margin increases from CCPs could amount to additional collateral demand of around US$25 billion.
  - Historical haircuts on HQLA increased in the range 0.5 percent to 7 percent during June 2007–June 2009 (CGFS, 2010).
  - Example single margin call: 3.5 percent increase (CGFS, 2010, Box 1).
  - Miglietta et al (2015) observed a hike of 3.5–5 percent in initial margins during the Eurozone crisis of November [text truncated].
  - Market-wide lost variation margin from defaulted but unsettled bilateral portfolios (summary choice): US$12 billion.
  - VMGH potential one-week loss estimate for extreme case at LCH: US$18.5 billion (assumption of a week tolerable period).
  - LCH average VM payment daily by all 55 Swapclear clearing members to LCH: US$3.7 billion.
  - Aggregate estimated market demand for HQLA triggered by a major, difficult default: about US$90 billion (sum of items estimated in the analysis).
- Table-excerpt numerical breakdown (IMF staff estimates):
  - 1. Default fund replenishment (multi-CCP): 22 22
  - 2. Initial margin increases (multi-CCP): 25 - 25
  - 3. Initial margin increases (uncleared market): 13 0.7 13.7
  - 4. Variation margin foregone (closed-out but unvalued bilateral trades with defaulter): - 12 12
  - 5. VMGH (single CCP): 18.5 18.5
  - Total: 53.2 91.2

### Collateral reuse, monetary metrics, and trends
- Restricting collateral re-use (rehypothecation) has reduced collateral velocity and tightens available liquidity for market participants and CCPs.
  - Example regulatory constraints mentioned:
    - EU Securities Financing Transactions Regulation (Regulation (EU) 2015/2365, articles 15ff).
    - EMIR (Regulation (EU) 648/2012, articles 39(8), 47).
    - SEC rule 15c3-3 (rehypothecation limited to 140 percent of the collateralized liability) in the United States.
  - CFTC in the U.S. has recently softened its stance on segregation; this will encourage re-use.
- Restricting re-use is characterized as a tight money policy that contrasts with key monetary authorities’ policies.
- Suggested conceptual integration: money metrics such as M0, M1, M2 should integrate sizable pledged collateral metrics (i.e., combinations such as M0+C0...M2+C2).
- Empirical observation:
  - Collateral reuse rate (collateral velocity) declined from about three as of end-2007 to below two as of end- (text cut off).
- Box 1 — global pledged collateral and collateral velocity (end-2017 figures):
  - Pledged collateral received by major banks that could be onward re-pledged: US$7.5 trillion (an increase of 25 relative to end-2016).
  - Aggregate pledged collateral sources:
    - Non-hedge funds (pensions, insurers, official sector, asset managers): US$1.5 trillion in securities on loan.
    - Hedge funds: AUM of US$3.0 trillion (end-2017); estimated pledged collateral to major banks from hedge funds: US$2.2 trillion.
    - Aggregate pledged collateral from non-hedge funds plus hedge funds: US$3.7 trillion.
  - Collateral velocity (end-2017): US$7.5 trillion / US$3.7 trillion, or just over 2.0.
  - Market conditions:
    - In Europe, HQLA in short supply (Bund repos are in the negative 50 bps range).
    - In the U.S., GCF (collateral rates) is close to 2 percent (200 bps) at present.
  - Observation: U.S. dollar-denominated HQLA should be able to satisfy much of worldwide HQLA demand.

### Historical and market-capacity context
- LCH and CC&G raised margins on HQLA by 3.5–5 percent, with some collateral being hiked by as much as 9–14 percent. On average, a 5 percent increase was observed across the range of maturities of collateral assets.
- Top-20 firms posted US$31 billion in initial margins on uncleared transactions in 2017.
- Approximately US$260 billion could be posted on such trades across the market, implying a haircut-related increase of US$13 billion (assumption: 25 percent of uncleared transaction collateral is “level 2”).
- Margin hikes imply firms must obtain and set aside an extra amount of US$0.7 billion of HQLA to satisfy LCR requirements (analysis assumption).
- Comparators:
  - HQLA held for LCR purposes by top-12 banks (2018 regulatory returns): around US$350 billion each.
  - Total collateral posted by top-20 firms in respect of derivatives in 2017 (ISDA): US$325 billion.
  - Fair value of securities received as collateral permitted to be sold or re-pledged: approximately US$10 trillion in 2007; declined to about US$6 trillion in recent years.
  - Average unweighted HQLA amount (Barclays, Citi, Goldman Sachs, HSBC, J.P. Morgan, Morgan Stanley as at June 2018): US$362 billion.
- Observations:
  - If VMGH is in effect, CCPs will not have released the defaulter’s collateral, so collateral supply is unlikely to be eased by release of defaulter assets.
  - Some CCPs not invoking VMGH may liquidate margin and default fund assets, providing supply.
  - Collateral velocity is beginning to inch higher for the first time since the Lehman crisis; regional differences noted (Europe HQLA short supply; opposite in the U.S.).

### Conclusions — key findings and policy implications
- Liquidity is the key parameter for clearing members and CCPs in severe stress scenarios where the waterfall is exposed.
- Surviving clearing members face multiple prudential hits on the “morning after” a big default of another clearing member; the most challenging prudential issue is the increase in liquidity coverage requirement.
- Surviving clearing members will need to secure highly-liquid assets (HQLA) to cover deemed or assumed cash outflows which spike markedly after a large default.
- Collateral dynamics and pro-cyclicality:
  - High-quality collateral is in high demand in private markets when there is stress in the financial system.
  - Collateral is inherently pro-cyclical; market stress following a major default could sharply increase demand for HQLA in a marketplace where supply is already constrained.
  - If underlying defaults relate to macroeconomic conditions, increased HQLA demand would add further pro-cyclicality.
- Prudential standards and cash as margin:
  - Prudential standards have tended to favor cash as margin by clearing members for cleared client business.
  - Clients with securities collateral will typically repo out securities to provide cash; cash received by the CCP is likely to be deposited with the central bank.
  - The push towards mandatory clearing by clients tightens money supply because cash deposited as margin is not available to the CCP or the wider market.
- Market capacity and mitigation:
  - Aggregate estimated market demand for HQLA triggered by a major, difficult default: about US$90 billion.
  - Market depth under current demand-supply conditions may be sufficient to absorb a demand for approx. US$100 billion of HQLA (paper estimate).
  - U.S. dollar-denominated HQLA could satisfy much of worldwide demand.
  - VMGH would appear to be the least unpleasant CCP remedy among severe recovery options.
- Supervisory and central bank roles:
  - In extreme conditions, supervisors may allow banks to adjust LCR-related holdings of HQLA; central banks may take action to stabilize the market, but banks should be ill-advised to rely on these possibilities.

*Italic: Source — wp18228 (2016) excerpt as provided.*

### Conclusions ............................................................................................................

### Conclusions

### Introduction and purpose
- Regulatory attention to over-the-counter (OTC) derivatives increased markedly since the financial crisis of 2008.
- Key post-crisis initiatives cited:
  - Group of Twenty direction that all standardized OTC derivatives should be cleared through CCPs, and that non-centrally-cleared derivatives should be subject to margin requirements (G-20, 2009; G-20, 2011).
  - Basel III liquidity coverage obligations (BCBS, 2015) identified as especially significant for clearing members in stress.
- Objective: assess the impact of prudential regulation on non-defaulting clearing members following a major default among their peer group, with particular attention to liquidity coverage requirements and collateral demand.

### Scope of analysis and framing
- The paper examines a scenario where a major clearing member defaults and the entire CCP waterfall is exposed, so that loss-allocation arrangements may come into play.
- The analysis focuses on collateral needs during stress and the interaction between CCP recovery tools and prudential regulation.
- The paper does not re-open debate on the adequacy of CCP resources; it assumes the end-of-waterfall scenario would arise only in highly unusual circumstances.

### Key mechanisms and concepts
- CCP loss-absorption resources ("waterfall") include:
  - Initial margin (collateral provided by a clearing member to support its own obligations).
  - “Skin-in-the-game” (CCP-held resources).
  - Default fund (mutualized resources provided by clearing members).
  - Capital (owners’ investment in the CCP).
  - Contingency arrangements for loss-allocation at the end of the waterfall.
- Distinction between margin types:
  - Initial margin: provided to cover potential future losses during the margin period of risk; typically exchanged at inception and may be adjusted; unidirectional to CCP for cleared contracts and bidirectional for uncleared contracts.
  - Variation margin: provided and adjusted more frequently, typically daily, to reflect changes in contract value.
- Liquidity in stress is not only cash; collateral (HQLA) and cash are intricately intertwined and can be used interchangeably by financial institutions to meet liquidity needs.

### Findings on prudential regulation and collateral demand
- Among regulatory influences, the liquidity coverage obligations under Basel III are identified as the most significant impact for clearing members in the wake of a major default.
- Other prudential regulatory measures and market demands will also affect clearing members, but the paper concludes:
  - The demand for collateral arising from relatively new prudential rules is manageable.
  - Variation margin gains haircutting (as a CCP strategy to restore itself) is not unduly disruptive.
- Restricting collateral re-use (rehypothecation) has reduced collateral velocity and tightens available liquidity for market participants and CCPs.
  - Example regulatory constraints mentioned:
    - EU Securities Financing Transactions Regulation (Regulation (EU) 2015/2365, articles 15ff).
    - EMIR (Regulation (EU) 648/2012, articles 39(8), 47).
    - SEC rule 15c3-3 (rehypothecation limited to 140 percent of the collateralized liability) in the United States.
  - Note: CFTC in the U.S. has recently softened its stance on segregation; this will encourage re-use.

### Collateral reuse and monetary metrics
- Restricting re-use is characterized as a tight money policy that contrasts with key monetary authorities’ policies.
- Suggested conceptual integration:
  - Money metrics such as M0, M1, M2 should integrate sizable pledged collateral metrics (i.e., combinations such as M0+C0...M2+C2) into thinking on financial lubrication.
- Empirical observation from the text:
  - The collateral reuse rate (or, collateral velocity) declined from about three as of end-2007 to below two as of end- (text cut off).

### Analytical conclusion
- Liquidity is the key parameter for clearing members and CCPs in severe stress scenarios where the waterfall is exposed.
- The paper’s analysis indicates that, while regulatory changes affect collateral demand, the resultant demand from prudential rules is manageable within the assessed scenario, and CCP recovery measures such as variation margin gains haircutting are not expected to cause undue disruption.

*Conclusions section, wp18228*

### 2016. In fact, pledged collateral used in financial transactions is probably at par with money,

### wp18228 - 2016. In fact, pledged collateral used in financial transactions is probably at par with money,

### Collateral, regulatory change, and liquidity metrics
- Pledged collateral used in financial transactions functions largely at par with money, especially if not all money flows to market transactions.
- Obligations affecting collateral supply:
  - Mandatory clearing and clearing-related obligations to clear OTC derivatives (Singh, 2010; Koeppl, 2012; Singh, 2013).
  - New requirement for parties to uncleared OTC derivatives to provide initial margin in the form of HQLA, with no netting and no rehypothecation (BCBS, 2015). Limited empirical analysis to date (cf. Cont, 2018).
  - Basel III prudential regulatory standards introduced liquidity metrics including the liquidity coverage ratio (LCR) (BCBS, 2013, paragraph 119).
    - LCR requires banks to compute potential net cash outflows over 30 days and hold HQLA in line with the net outflow.
    - Under stress (an end-of-waterfall market scenario) presumed outflows increase markedly, driving up market demand for HQLA.

### Test scenario in a post-default environment — simultaneous stresses on a non-defaulting clearing member
- Three simultaneous changes to be managed:
  - Actions of the CCP handling the default.
  - The clearing member’s bilateral uncleared portfolio with the defaulter (ordinarily closed out).
  - The clearing member’s bilateral uncleared portfolios with non-defaulters (which continue).
- CCP default-management actions and possible outcomes:
  - CCP attempts to re-establish a matched book via auction and transfer; success depends on realistic bids.
  - Failed auction risks exhausting the CCP’s default waterfall; CCP may need alternative measures (tear-up of positions or haircutting variation margin gains).
  - End-of-waterfall scenarios are considered realistic by some studies (Lin and Surti, 2013; Paddrik and Young, 2017; Capponi et al., 2018).
  - Relevant scale examples:
    - Gross notional (open interest) for LCH (SwapClear operator): US$164 trillion versus resources immediately available for a typical SwapClear clearing member: US$11.65 billion.
    - Comparable figures for CME: US$16 trillion and US$5.78 billion.
- Potential clearing-member impacts from a major default where auctions fail:
  - Increase in initial margin required to support non-defaulters’ cleared portfolios; hikes cannot be ruled out.
  - Utilization of default fund contributions of non-defaulters via CCP “assessment” rules (replenishment obligations).
  - Possible tearing-up, wholly or in part, of transactions to neutralize the defaulter’s portfolio—requires valuation machinery that may be impaired.
  - Withholding variation margin gains (VMGH) as a tool: CCP retains variation margin due to in-the-money non-defaulting members, thereby supplying CCP with cash for default management; gainers irrevocably lose their gains while out-of-the-money losers continue to pay.
    - Scenario assumption: LCH implements VMGH; no other CCPs do.
- Clearing members as service providers:
  - “Pay-as-paid” clauses typically enable clearing members to pass losses on client positions to clients; prudential derogations may apply when such clauses are in place (cf Regulation (EU) 575/2013, Article 306).

### Uncleared portfolios in the post-default scenario
- Close-out of transactions with the defaulter may be impaired if market liquidity is dysfunctional (as signaled by CCP auction failure); collateral liquidation may not realize values.
- A non-performing uncleared portfolio accrues market risk without variation margin inflows — similar in effect to VMGH on cleared portfolios.
- Surviving transactions with other non-defaulters will likely see:
  - Increases in initial margin obligations on both sides.
  - Haircut increases reflecting impaired collateral values and fire-sale pressures (depressed market-making increases haircuts).
  - Revaluation effects where credit values influence transaction valuations, raising potential future exposure and requiring additional margin.

### Prudential regulation effects on surviving clearing members and HQLA supply
- Regulatory incentives favor clearing; special prudential treatment accompanies mandatory clearing.
- Eight prudential metrics could affect cleared business; some are only moderately affected, others more substantially.
  - Examples of moderately affected metrics: capital requirements for counterparty risk (exposure to CCP and clients), leverage ratio.
  - Utilization of a surviving clearing member’s default fund contribution is a deduction from regulatory capital.
    - LCH 2018 data: top 10 clearing members contribute on average 3.1 percent of the default fund.
    - Capital requirement uplift for a surviving clearing member from loss of its contribution is probably limited to about 10 percent, or US$1.7 million.
    - Basel III does not treat a CCP as an impaired credit after default-fund utilization, so CCP trouble does not automatically translate into capital adequacy hits for clearing members as CCP creditors.
- Metrics more substantially affected:
  - VMGH increases position risk capital charges because members are left with unhedged positions while gains are withheld.
  - Liquidity coverage ratio (LCR) is the most significant channel affecting HQLA demand:
    - Clearing members must assess expected cash outflows over the next 30 days and hold HQLA to cover net outflows.
    - Specific LCR impacts post-default:
      - Default fund utilization or expected utilization creates a 30-day replenishment outflow that must be expected and covered by HQLA.
      - Increases in initial margin raise liquidity needs; Basel III obliges collateral-providers to retain HQLA of 20 percent of the value of initial margin posted where posted collateral is not “level 1” assets (BCBS, 2013, paragraph 119).
        - Effect: each margin hike has a real impact of more than 100 percent of the additional margin called when collateral is not level 1.
      - VMGH reduces expected future cash inflows (variation margin) and those inflows cannot be counted when assessing liquidity; clearing members must evaluate duration of VMGH up to 30 days and cover reduced inflows with HQLA.
        - On cleared client business with non-affiliated clients, variation margin not received likely need not be passed on; where “pay-as-paid” clauses exist, variation margin cuts are passed on.
- Uncleared business under prudential rules:
  - Similar metrics apply to uncleared portfolios with differences in implementation.
  - If close-out of defaulter-related uncleared transactions is impaired, survivors hold non-performing portfolios without variation margin receipts and must account for likely lost inflows over 30 days and cover with HQLA.
  - Continuing uncleleared transactions with other survivors face increased capital requirements (widened credit spreads increasing the CVA charge) and collateral liquidity stress.
  - New regulation requires initial margin for uncleared trades provided as HQLA, with gross, non-rehypothecatable transfers and a 10-day margin period of risk (BCBS, 2015). Re-evaluation of collateral amounts in stressed markets will likely increase initial margin obligations.

### Impact of market stress on collateral supply — immediate simultaneous HQLA demands
- Surviving clearing members will likely face unusual, simultaneous, and potentially unplanned HQLA demands:
  - Immediate need for cash or HQLA to back expected CCP default-fund replenishment demands; expected assessments must be backed dollar-for-dollar by HQLA while awaiting formal calls.
  - Initial margin hikes impose HQLA requirements, scaled up by an additional 20 percent for collateral that is not “level 1” due to LCR effects.
  - Expected variation margin receivable from cleared and uncleared defaulted portfolios may not be received (VMGH for cleared; zombie portfolios for uncleared), reducing cash inflows and necessitating higher HQLA holdings for liquidity coverage.
- LCR Impact of Altered Margin Behavior Following Default (summary)
  - Cleared portfolio:
    - Initial margin: Increased IM requirement; additional 20 percent on some assets due to LCR.
    - Variation margin: VM receipts withheld by CCP; LCR requires forward summation of lost receipts.
  - Uncleared portfolio:
    - Initial margin: Increased IM requirement on master agreements with surviving counterparties; additional 20 percent due to LCR.
    - Variation margin: VM receipts non-performing on master agreement with defaulter; LCR requires forward summation of lost receipts.
  - (Table source: IMF staff estimates.)
- Quantifying the demands and mitigation via released collateral:
  - Default fund utilization:
    - LCH default fund: US$6.7 billion.
    - Total commitments by clearing members across CCPs: approximately US$75 billion (Khwaja, 2018).
    - It is improbable that a single default would wipe out default funds across all CCPs simultaneously.
    - A single full replenishment for four CCPs (LCH, CME, ICE, Eurex) is approximately US$22 billion (Khwaja, 2018).
    - Liquidating non-HQLA assets to meet top-ups is possible but market liquidity in extreme scenarios is uncertain and not analyzed here.
  - Initial margin increases:
    - Historical evidence from CGFS (2010) shows haircuts applicable to HQLA increased in the range 0.5 percent to 7 percent during June 2007–June 2009.
    - CGFS (2010, Box 1) gives an example of a single margin call representing a 3.5 percent increase in margin.
    - Miglietta et al (2015) observed a hike of 3.5–5 percent in initial margins during the Eurozone crisis of November [text truncated at source].

*Italic: Source — wp18228 (2016) excerpt as provided.*

### 2011. LCH and CC&G raised margins on HQLA by 3.5–5 percent, with some collateral

### 2011. LCH and CC&G raised margins on HQLA by 3.5–5 percent, with some collateral

### Margin increases and initial margin exposure
- LCH and CC&G raised margins on HQLA by 3.5–5 percent, with some collateral being hiked by as much as 9–14 percent. On average, a 5 percent increase was observed across the range of maturities of collateral assets.
- Initial margins posted to CCPs are estimated to be US$500 billion.
- Initial margin posted for cleared interest rate and credit derivatives: US$194 billion.
- If surviving clearing members worldwide experience another average 5 percent hike, haircut-related initial margin increases from CCPs could amount to additional collateral demand of around US$25 billion.
- Initial margins required under new Basel requirements for uncleared transactions:
  - Top-20 firms posted US$31 billion in initial margins on uncleared transactions in 2017.
  - Approximately US$260 billion could be posted on such trades across the market, implying a haircut-related increase of US$13 billion (with the bulk likely concentrated on banks).

### Liquidity Coverage Ratio (LCR) implications
- LCR requirement to hold HQLA of 20 percent of the value of initial margin consisting of “level 1” assets.
- Margin hikes imply firms must obtain and set aside an extra amount of US$0.7 billion of HQLA to satisfy LCR requirements (based on assumptions in the analysis).
- Estimated proportion of LCR-eligible HQLA that is “level 1”: approximately 75 percent.
- Assumption: 25 percent of uncleared transaction collateral is “level 2” and subject to the 20 percent LCR requirement.

### Loss of receipts: Defaulted master agreements (variation margin forgone)
- Lehman Brothers context and empirical observations:
  - Lehman’s derivatives notional principal: US$35 trillion.
  - Comparable notional principal of the top four U.S. banks today: around US$38 trillion each.
  - Derivatives claims filed against Lehman ranged from US$45 billion to US$51 billion, of which US$22 billion were concentrated among the top 13 bank counterparties.
  - Success rate for claims allowed to rank in the bankruptcy: 47.4 percent.
  - Estimated actual transaction-related losses maybe US$30 billion across the whole bilateral market; US$10.3 billion loss for the top-13, maybe around US$20 billion across the market in one assessment.
- Theoretical approach (Heath et al., 2015):
  - Expected exposures given initial margin at 99 percent confidence: US$1 billion.
  - Uncovered losses in extreme conditions (2.67 standard deviations): US$93 billion.
  - Conservative single-bank lost variation margin estimate derived: around US$5 billion.
- Summary choice for market-wide lost variation margin due from defaulted but unsettled bilateral portfolios in a major default: US$12 billion (mid-point between theoretical and empirical approaches).

### Loss of receipts: VMGH (variation margin gains haircut)
- LCH data: average VM payment daily by all 55 Swapclear clearing members to LCH is US$3.7 billion.
- Scenario assumptions:
  - VMGH would be used only in very extreme cases.
  - A plausible tolerable period of VMGH assumed: a week.
  - Market participants collectively unlikely to bear VMGH-related losses of more than US$18.5 billion in the week following a catastrophic default.
  - LCH rulebook limits and possible escalation: with clearing member vote, VMGH could be extended; quantitative disclosures suggest ceilings could come in at somewhat below 4*default fund size (US$26 billion approximately) in certain scenarios.
- Assumption that it is unlikely more than one CCP would need to implement VMGH simultaneously.

### Overall market impact on HQLA requirements
- Aggregate estimated market demand for HQLA triggered by a major, difficult default: about US$90 billion (sum of items estimated in the analysis).
- Contextual comparisons:
  - HQLA held for LCR purposes by top-12 banks (2018 regulatory returns): around US$350 billion each.
  - Total collateral posted by top-20 firms in respect of derivatives in 2017 (ISDA): US$325 billion.
  - Fair value of securities received as collateral permitted to be sold or re-pledged:
    - Approximately US$10 trillion in 2007.
    - Declined to about US$6 trillion in recent years (prior to the analysis).
  - Average unweighted HQLA amount (Barclays, Citi, Goldman Sachs, HSBC, J.P. Morgan, Morgan Stanley as at June 2018): US$362 billion.
- Observations on collateral supply:
  - If VMGH is in effect, CCPs will not have released the defaulter’s collateral, so collateral supply is unlikely to be eased by release of defaulter assets.
  - Some CCPs not invoking VMGH may liquidate margin and default fund assets, providing supply.
  - U.S. dollar-denominated HQLA should be able to satisfy much of worldwide HQLA demand.
  - Collateral velocity is beginning to inch higher for the first time since the Lehman crisis; regional differences noted (Europe HQLA short supply; opposite in the U.S.).
- Policy and supervisory notes:
  - In extreme conditions, supervisors may allow banks to adjust their LCR-related holdings of HQLA; central banks may take action to stabilize the market, but banks should be ill-advised to rely on these possibilities.
  - The LCR calculation could differ if a bank experienced substantial inflows, but this was not modeled and is viewed as unlikely during extreme market stress.

*Source: wp18228 - 2011. LCH and CC&G raised margins on HQLA by 3.5–5 percent, with some collateral*

### 1.      Default fund replenishment (multi-

### 1.      Default fund replenishment (multi-CCP)

### Numerical breakdown (table excerpts)
- 1. Default fund replenishment (multi-CCP): 22 22
- 2. Initial margin increases (multi-CCP): 25 - 25
- 3. Initial margin increases (uncleared market): 13 0.7 13.7
- 4. Variation margin foregone (closed-out but unvalued bilateral trades with defaulter): - 12 12
- 5. VMGH (single CCP): 18.5 18.5
- Total: 53.2 91.2
- Source: IMF staff estimates.

### Box 1 — The Demand/Supply of Global HQLA—the Macro Picture (via Collateral Reuse Rate)
- As of end-2017, the pledged collateral received by the major banks that could be onward re-pledged in their own name was US$7.5 trillion, an increase of 25 relative to end-2016.
- After a decade of approximately US$6 trillion market for pledged collateral, most global banks and a couple of newcomers from Canada were instrumental in this increase.
- Pledged collateral sources:
  - Non-hedge funds (pensions, insurers, official sector, asset managers): US$1.5 trillion in securities on loan (without secondary market churning).
  - Hedge funds: AUM of US$3.0 trillion (end-2017); estimated pledged collateral to major banks from hedge funds: US$2.2 trillion.
  - Aggregate pledged collateral from non-hedge funds plus hedge funds: US$3.7 trillion.
- Collateral velocity (end-2017): US$7.5 trillion/ US$3.7 trillion, or just over 2.0.
- Market conditions and rates:
  - In Europe, HQLA continues to be in short supply (Bund repos are in the negative 50 bps range).
  - In the U.S., GCF (collateral rates) is close to 2 percent (200 bps) at present.
  - U.S. dollar-denominated HQLA should be able to satisfy much of the worldwide HQLA demand.
- Market depth under current demand-supply conditions may be sufficient to absorb a demand for approx. US$100 billion of HQLA (estimated in this paper, re the “morning after”).

### Conclusions — Key findings and policy implications
- Surviving clearing members face multiple prudential hits on the “morning after” a big default of another clearing member; the most challenging prudential issue is the increase in liquidity coverage requirement.
- Surviving clearing members will need to secure highly-liquid assets (HQLA) to cover deemed or assumed cash outflows which spike markedly after a large default.
- Collateral dynamics:
  - High-quality collateral is in high demand in private markets when there is stress in the financial system.
  - Collateral is inherently pro-cyclical; market stress following a major default could sharply increase demand for HQLA in a marketplace where supply is already constrained.
  - If underlying default causes relate to macroeconomic conditions, the increased HQLA demand would add further pro-cyclicality.
- Prudential standards and cash as margin:
  - Prudential standards have tended to favor cash as margin by clearing members for cleared client business.
  - Clients with securities collateral will typically repo out securities to provide cash; cash received by the CCP is likely to be deposited with the central bank (example: Fed offers IOER, a preferred rate for depository institutions, to CCPs).
  - The push towards mandatory clearing by clients tightens money supply because cash deposited as margin is not available to the CCP or the wider market.
- Collateral supply constraints can amount to a tightening of quasi-money supply, whether intentional or not; following a major default, this tightening is unusual but potentially significant.
- Mitigating factors and market capacity:
  - The concern that the market may not cope with increased HQLA demand may be overstated given U.S. conditions: collateral velocity is inching higher for the first time since the Lehman crisis.
  - U.S. dollar-denominated HQLA could satisfy much of worldwide demand.
  - Market depth may be sufficient, under current monetary (including collateral-supply) conditions, to absorb a demand for up to US$90 billion of HQLA.
  - If the market can absorb that demand, actions by CCPs following a default, which pass through to clearing members and clients, could be managed.
  - VMGH would appear to be the least unpleasant remedy for a CCP in difficulty.

*Source: IMF staff estimates and text as provided in the chapter.*

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_Source: https://www.imf.org/-/media/files/publications/wp/2018/wp18228.pdf_