Simulating liquidity stress in the derivatives market

Abstract

We investigate whether margin calls on derivative counterparties could exceed their available liquid assets and, by preventing immediate payment of those calls, spread such liquidity shortfalls through the market. Using trade repository data on derivative portfolios, we simulate variation margin calls in a stress scenario and compare them with the cash buffers of the institutions facing the calls. Where buffers are insufficient we assume institutions take remedial action such as borrowing to cover the shortfalls, but only after waiting as long as possible to receive payments before making their own. Such delays can force recipients into more extensive remedial action than otherwise. Hence, liquidity shortfalls can grow in aggregate as they spread through the network. However, we find an aggregate liquidity shortfall equivalent to only a modest fraction of average daily cash borrowing in international repo markets. Moreover, we find that only a small part of this aggregate shortfall could be avoided if payments within the counterparty network were coordinated by an external authority.