Published as part of the Financial Stability Review, May 2022.
Synthetic leverage has become an important feature of the financial system. It refers to the exposure embedded in derivative contracts. These instruments allow market participants to gain synthetic exposure to the market, sometimes at lower cost (for certain types of derivatives and underlying assets), and allow them to magnify gains at the risk of magnifying losses. Leverage tends to be less strictly regulated in parts of the non-bank financial sector than it is for banks and non-bank institutions are able to increase leverage synthetically inexpensively. In events such as the bankruptcy of Long-Term Capital Management and the collapse of AIG, and more recently Archegos, losses on derivative exposures have spread to banking counterparties.
There are several ways to measure the amount of leverage in the financial system. Traditional entity-level leverage ratios do not fully account for the contingent liabilities associated with derivative positions, as future gains and losses may significantly exceed the market value at which the derivatives are recorded on the balance sheet. A generally accepted method used to capture synthetic leverage applies the concept of cash equivalent portfolios, which also forms the basis for leverage measures in the regulation of EU funds. Another approach, which is the focus of this box, looks at the derivative contracts themselves and assesses the extent to which these contracts can be used to take positions that incorporate leverage.
This box explores the link between synthetic leverage and margin from two angles. First, we look at the relationship between the gross notional value (GNV) of derivatives and the initial margins (IM) displayed, which can be thought of as the level of synthetic leverage in a particular type of contract. Low levels of MI allow financial institutions to increase their market exposure through derivatives with very little upfront funding. During periods of high price volatility, IMs tend to rise relative to GNV, which offers the benefit of better protection against counterparty risk in stressed market conditions. However, it may also intensify liquidity needs in a procyclical manner and create incentives for deleveraging, which could contribute to the amplification of price declines. Second, we calculate the ratio of absolute daily flows of variation margins (VM) to MI, which can be seen as a proxy for profit and loss amplification on a derivative portfolio. For a highly leveraged portfolio, this ratio would increase more in times of high market volatility. Daily ratios above 1 suggest – ex post – that the capital committed as an IM would not have been sufficient to fully protect against losses if the counterparty had gone bankrupt. These two measures are calculated for portfolios of equity derivatives held by non-banking financial institutions in order to capture risks similar to those faced by Archegos.
The high GNV/IM multipliers for equity derivatives suggest that these instruments could carry potentially high leverage risk. Multipliers vary between 10 and 80 depending on the instrument for most of the period covered, with stock options showing the highest multipliers (Table A, panel a). Although the GNV/IM ratio decreased for equity futures during the March 2020 market turmoil, it did not decrease significantly for swaps and options, the difference likely stemming from the models used to calculate the IMs. Following this episode, the GNV/IM ratio for options and futures increased for most of 2020 and 2021, with the increase accelerating in the fourth quarter of 2021. The increase in the ratio for options appears to have was driven by a decrease in MI. because the associated NGV remained relatively stable during this period. The GNV/IM ratio of swaps is relatively stable.
The ratios between daily absolute flows of VMs and MIs at the instrument level increased significantly in March 2020, reaching more than 1 for some NBFIs (Chart A, Panel B). While the majority of NBFIs posted more MI than the number of VM calls, for a significant number of non-bank VM calls exceeded MI during the March 2020 market turmoil, suggesting that some counterparties would not have been fully covered by the IM if the other counterparty had defaulted. Focusing on NBFIs with high exposure to market volatility, the median VM/IM ratio in the upper 20th percentile ranged from 1.7 to 2.5 in March 2020 for all instruments considered. The significant increase in VM calls also indicates potential liquidity stress from derivative positions. The median futures and options ratio also increased in February and March 2022, reflecting higher volatility, although the levels reached are not comparable to those of March 2020. This also reflects the fact that recent events have more affected energy and commodity derivatives. than equity derivatives.
The GNV/IM ratio is an approximation of the synthetic leverage of a derivative portfolio, while the VM/IM ratio captures portfolio-level profit and loss amplification
Leverage risk can materialize through margin calls and unhedged exposure to a counterparty during periods of high market volatility. One of the main risks associated with embedded leverage in derivatives portfolios is the resulting pro-cyclical margin calls during periods of market stress. Moreover, the IM may not always be sufficient to cover any counterparty risk in periods of very high market volatility. Higher levels of MI in calmer periods could be beneficial from a financial stability perspective, as it could reduce the procyclicality of margin calls, as well as leverage-type risk in derivatives portfolios . However, there are trade-offs to consider, including the possible indirect impact that derivatives may have on users due to higher liquidity and funding requirements.