Optimal Margining and Margin Relief in Centrally Cleared Derivatives Markets

A major policy challenge posed by derivatives clearinghouses is that their collateral requirements can rise sharply in times of stress, reducing market liquidity and further exacerbating downturns. Smoothing sharp changes in collateral requirements - an approach known as through-the-cycle margining - however, has its own disadvantages, one of which is increased risk sharing among clearinghouse members when financial risk is high. This can give rise to undesirable side effects, including distorted incentives, which can reverse the conventional knowledge about collateral policy. In contrast to the existing literature, I show that through-the-cycle margining can increase as well as reduce trading in volatile markets. Due to increased risk sharing, clearinghouse members may prefer to overcollateralize transactions, leading to lower than socially optimal trading. This creates a challenge for policy-makers, since it may be challenging to push for lower collateral standards than deemed proper by the industry. For such cases, I propose an alternative policy tool - increasing default penalties - to align private and social incentives.