Procyclical variation margins in central clearing

Abstract

This study analyzes the effect of asset prices on the daily exchange of profit and loss from derivatives contracts in central clearing, called variation margin (VM). It provides empirical evidence that the VM exhibits a high volatility and a significant relation to changes in market prices. The magnitude of VM procyclicality has significant implications for systemic risk. This study analytically shows that an internal loan facility can reduce liquidity hoarding and external funding during stress periods and thus contribute to contain systemic risk. In addition, this study proposes a new scheme called the posting of variation margin in securities (PVMS) clause as an example of internal loan facility between the contract counterparties. The PVMS can replace cash VM payments with collateral posting in times of market stress.