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 the 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 these with the liquid-asset buffers of the institutions facing the calls. Where buffers are insufficient we assume institutions borrow additional liquidity to cover the shortfalls, but only at the last moment when payment is due. Such delays can force recipients to borrow more than otherwise, and so liquidity shortfalls can grow in aggregate as they spread through the network. However, we find an aggregate liquidity shortfall equivalent to only a small 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 were coordinated centrally.

Intermediation in Us and EU Bond and Swap Markets: Stylised Facts, Trends and Impact of the Coronavirus (Covid-19) Crisis in March 2020

“…Overall, there is evidence that the rise in HQLA needs seems to be manageable. According to Bardoscia et al (2019), aggregate liquid asset buffers for derivatives were roughly USD 700 billion, thereby providing ample resources for margin calls. We will return to the actual impact of margin calls in the analysis of the COVID-19 crisis in the next section.…”

The physics of financial networks

“…More recently, a few studies have focused on liquidity shocks originating from the derivatives market, see e.g. 71,104,105 .…”

Evaluating Market Risk from Leveraged Derivative Exposures

“…Fukker et al (2022) study how overlapping portfolios provide a channel for financial contagion induced by the market price impact of asset deleveraging. Bardoscia et al (2019b) analyse the network of exposures constructed by using the UK trade repository data and study how liquidity shocks related to variation margins propagate across the network and translate into payment deficiencies across different derivative markets. They find that in extreme theoretical scenarios where liquidity buffers are small, a handful of institutions may experience significant spillover effects due to the directionality of their portfolios.…”