Macroprudential Margins: A New Countercyclical Tool?

Abstract

We quantify the size of a fire-sale externality in the derivatives market in the absence of a macroprudential buffer on top of microprudential initial margin requirements. We show how this varies over the financial cycle with market volatility. We then assess the ability of a macroprudential buffer to reduce this externality. We find this depends critically on the release conditions of the buffer. A buffer could reduce or, if set appropriately, even eliminate the externality, as long as it was released when investors faced any significant collateral calls, regardless of whether these related to variation or initial margins. However, it could be harmful if it was released only with calls for additional initial margin. Predicated on ideal release conditions, we test the performance of macroprudential buffers based on ‘anti-procyclicality’ mechanisms in current regulations. These mechanisms can reduce the fire-sale externality in some market conditions, but not all. Conceptually, we devise alternative mechanismsthat eliminate the externality, although it may be difficult for policymakers to specify these in practice. Finally, as an alternative to quantity-based solutions, we investigate the ability of taxes to reduce the externality. We find that such a price-based solution could also eliminate the externality if set appropriately, but this would require a high tax rate and the redistribution of significant tax revenues.