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Optimal Margining and Margin Relief in Centrally Cleared Derivatives Markets

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  • Radoslav Raykov

Abstract

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.

Suggested Citation

  • Radoslav Raykov, 2014. "Optimal Margining and Margin Relief in Centrally Cleared Derivatives Markets," Staff Working Papers 14-29, Bank of Canada.
  • Handle: RePEc:bca:bocawp:14-29
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    References listed on IDEAS

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    6. Gibson, Rajna & Murawski, Carsten, 2013. "Margining in derivatives markets and the stability of the banking sector," Journal of Banking & Finance, Elsevier, vol. 37(4), pages 1119-1132.
    7. Pradeep Dubey & John Geanakoplos & Martin Shubik, 2005. "Default and Punishment in General Equilibrium," Econometrica, Econometric Society, vol. 73(1), pages 1-37, January.
    8. Thorsten V. Koeppl, 2013. "The Limits Of Central Counterparty Clearing: Collusive Moral Hazard And Market Liquidity," Working Paper 1312, Economics Department, Queen's University.
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    Cited by:

    1. Dávid Zoltán Szabó & Kata Váradi, 2022. "Margin requirements based on a stochastic correlation model," Journal of Futures Markets, John Wiley & Sons, Ltd., vol. 42(10), pages 1797-1820, October.
    2. Nikil Chande & Nicholas Labelle, 2016. "Using Speed and Credit Limits to Address the Procyclicality of Initial Margin at Central Counterparties," Discussion Papers 16-18, Bank of Canada.
    3. Héctor Pérez Saiz & Gabriel Xerri, 2016. "Credit Risk and Collateral Demand in a Retail Payment System," Discussion Papers 16-16, Bank of Canada.

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    More about this item

    Keywords

    Economic models; Payment clearing and settlement systems;

    JEL classification:

    • G19 - Financial Economics - - General Financial Markets - - - Other
    • G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages

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