Banks and CCPs facing stressed derivatives markets

17 November 2022

ECB Banking Supervision has in recent months been closely monitoring energy market developments and their impact on the banking sector. The European energy sector is facing a potentially severe supply shock: the Russian invasion of Ukraine led to a sudden decrease in Europe’s natural gas supplies, while maintenance issues in nuclear power plants and droughts reducing hydropower generation have exacerbated the situation further. As a result, power and gas prices surged, and despite cooling significantly, they have remained volatile throughout autumn 2022, impacting banks’ clients and creating pressure points in financial markets. In particular, large swings in energy prices resulted in a more volatile valuation of derivative positions traded via European Central Counterparties (CCPs). This triggered sizeable margin calls, affecting commodity traders and energy utilities that hedged their exposures via CCPs.

Due to the reforms in the aftermath of the Global Financial Crisis, CCPs are playing an increasingly important role in mitigating counterparty credit risk in derivatives transactions. These trades used to be cleared bilaterally by market participants, which had led to contagion after the default of Lehman Brothers. To cover their risks and ensure they can cope with the potential default of a participant, CCPs collect funds and collateral from clearing members and their clients in the form of margin calls. Since February 2022, initial margins held by European commodity CCPs have markedly increased and created a wider liquidity impact: for instance, total initial margins held by European Commodity Clearing (ECC), the largest commodity CCP in the EU, increased from €5 billion in March 2021 to about €86 billion in August 2022. In addition to initial margin (which may be paid in either cash or non-cash collateral), CCPs collect variation margin, i.e. pass-through cash payments from one side of a derivatives transaction to another, reflecting daily mark-to-market changes in the value of the underlying contract.

Given the significant market volatility, these margin calls created a liquidity strain on certain energy utilities and traders, as they rushed to come up with cash to cover their margin calls. Banks responded to the significant liquidity demand from the energy sector and increased the volume of credit and liquidity lines to these firms. However, such support is constrained by each bank’s risk limits. Banks have been responding well to the situation and have already been providing sizeable liquidity support to their clients, and there appears to be undrawn liquidity capacity still in the system. However, certain banks may at some point start to reach their limits vis-à-vis the energy sector.

A default of an energy firm active in centrally-cleared markets has been avoided, although some struggling energy utilities – which are typically not cash-rich despite having considerable assets – had to request public sector support to help them meet their margin calls.

If a bank under European banking supervision is an important clearing member of a CCP, the ECB has a seat in the CCP’s supervisory college, where it cooperates and exchanges information with other authorities. In parallel, the ECB is also engaging increasingly with clearing member banks as part of the day-to-day supervision, focusing on potential risks from the current situation, as well as banks’ risk management approach and interaction with CCPs. Through both these channels, ECB Banking Supervision will continue to closely monitor developments at European CCPs and their potential impact on banks.

Overall, the system proved resilient, and major disruptions and defaults in European CCPs have been avoided. Still, the risks associated with CCPs’ increased role in financial markets should be managed carefully. Going forward, the ECB in both its banking supervision and central banking functions will continue to closely monitor developments and will cooperate with the European Securities and Markets Authority and national competent authorities to support the common objective of enhancing CCP transparency and ensuring a stable financial system, including by maintaining prudent standards for collateralisation for both clearing members and CCPs, so that they remain resilient. In this vein, it would be important for clearing member banks to keep working with CCPs to improve the predictability of margin calls, particularly for non-bank clients, and to better manage potential procyclical effects of large margin calls in times of market stress. For as long as the crisis continues and prices are volatile, banks and supervisors alike must remain attentive and vigilant.