Margin scuffle at Eurex blurs lines between risk and returns

Disagreement over liquidity risk add-ons may owe more to self-interest than risk management

Last week, Eurex Clearing finalised some long-awaited tweaks to its policy governing margin add-ons for outsized positions in fixed income futures. The bourse dutifully consulted its members before making the changes: what sounds like an arcane rule has major risk management implications for clearing brokers and their clients.

What Eurex probably didn’t expect was the ferocious disagreement that erupted among clearing firms after it put the proposal out to consultation.

The bourse sought members’ views on two points: the parameters that determine how liquidity risk add-ons should scale up to account for a position that is large relative to the underlying market; and whether or not these add-ons should be charged in the first instance to clearing members or, as was ultimately agreed should remain the case, directly to their clients.

A mooted change to this second point is understood to have rung alarm bells among members. Many argued vociferously that the way in which add-ons are charged has the potential to benefit certain large incumbent clearing providers – many (though not all) of them being US banks – or mid-tier challengers, many of them (though not exclusively) being European banks.

Clearing brokers have long complained that it can be difficult to pass through charges to large clients that use their influence to question what they see as unnecessary additional costs of doing business. Besides, they argue, levying add-ons directly abides by the ‘defaulter pays’ principle: those who bring the risk into the CCP should pay to cover it. Many futures commission merchants (FCMs) cheered CME’s decision to bake these add-ons into baseline initial margin requirements for its new Span 2 margin framework.

FCMs in favour of keeping the status quo at Eurex – charging add-ons directly to clients – argue it keeps things simple, and makes clients directly accountable for the positions they hold. It could also make porting positions easier during a default, they point out: if clients have dutifully posted margin commensurate with their risk, it should be easier to effectively segment them from a defaulting broker.

But proponents of change point to strong counterarguments. Firstly, large FCMs may have knowledge of offsetting positions a client holds bilaterally or at another clearing house, which a CCP can’t see. By charging add-ons at the member level, large FCMs can effectively net out the positions the client holds, while actively managing the exposure to the clearing house. Clients that have netted positions should not be penalised in a way that implies they hold only directional risk, they argue.

Their other argument – and here, the line between prudent risk management and commercial self-interest starts to get fuzzy – runs something like this: if a client clears 100% of an outsized position in Bund futures with one FCM, under Eurex’s policy, it is required to post a 1.4 times multiplier on its initial margin to account for the liquidity risk it poses. But if that client instead chooses to split its portfolio in two, holding 50% of the position at two separate FCMs, this is not required.

The client no longer has to pay a concentration add-on because the clearing house does not perceive it as a concentrated single position at one FCM – the risk posed by the default of that client is, to an extent, obscured.

Viewed this way, the current policy incentivises clients to share their positions among a wider group of clearers – potentially disadvantaging the handful of large, mostly US-based FCMs that dominate the clearing landscape, some of which are said to have scented an opportunity for change in Eurex’s consultation.

The episode is a timely reminder of the awkward nature of the stakeholder debates that determine often critical CCP policies – and the fine line the CCP itself has to tread on margin policy, as well as the overseers charged with holding them to account. All sides make pertinent points about how best to effectively parse and manage risk, but self-interest lingers uncomfortably in the background.

“For once, it was the members who were conflicted, not the CCP,” says an executive at a clearing broker.