• Initial margin haircuts could be measure to protect taxpayers
  • EU Commission's Merlin says no decision made on IM haircuts

European Union regulators are considering whether to recommend haircuts on initial margins as a tool for dealing with failing central counter-parties, said Martin Merlin, financial markets director in the EU Commission’s financial stability division.

The commission is preparing draft legislation, due either late this year or early next, for how to deal with clearing houses when they fail, Merlin said at a Brussels conference sponsored by research group Centre for European Policy Studies. As part of the work, officials are looking at available tools that would avoid the need for public funds.

Some tools are already well known and accepted, including cash calls, variation margin haircuts as well as the potential forced allocation of contracts among non-defaulting members, he said. Still, regulators may need to look further.

“One issue that is open in my view, and lots of regulators are discussing that right now, is whether we need to add initial-margin haircutting,” Merlin said. “It’s clearly within the initial margins that you have the biggest pot of money.”

Still, the issue isn’t clearcut and nothing has been proposed yet, he said. Such haircuts may conflict with bankruptcy laws in some countries, and could also allow regulatory arbitrage between the U.S. and the EU, he said.

“So the question is, can you do without the biggest pot of money, or in order to make sure that the taxpayer is completely off the hook, should you also as a last resort envisage initial margin haircutting?” Merlin said. “That is a central issue for us now.”

The measure could cause immediate liquidity problems, Dennis McLaughlin, group chief risk officer at LCH Clearnet, said in response to Merlin’s comments. That’s because clearing members have a choice of offering cash or securities as margin, and securities go in a custodian box, he said.

“We can’t actually touch them,” McLaughlin said. “If suddenly we did IM haircutting, the members would choose not to give us any cash and that would create a real problem in terms of how much cash we have on hand to deal with the stress events when they happen.”

The haircuts, if proposed, would be used only as a last resort to safeguard taxpayers, Merlin said. Margin accounts wouldn’t be used to create a standing fund in advance of emergencies, and whether any such funds are needed is a separate issue, he said.

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