Latin American Capital Markets

DESIGNING A DERIVATIVES COMPLEMENTTO CASH MARKETS 369CapitalCapital requirements in derivatives markets generally secure overnight exposure onfutures positions, that is, the risk that the price will move in an amount greater thanthe standing margin (or secured risk) before the prior day's variation is collected. Assuch, the capital requirement is designed to ensure a high level of liquidity or marketstaying power, that is, to ensure that obligations can be met as they become due. Regulatoryminimum capital requirements generally would not be sufficient to cover outlierevents, an extended period of accumulated losses, or multiple failures or to act asa substitute for vigilant risk management controls at member firms and exchanges.Regulation should assume that capital requirements, even assuming "haircuts" (adjustmentof collateral value to reflect the market risk of converting it to use), must besupplemented by other risk management measures, such as stress testing, to ensurethat available financial resources are adequate to cover actual and projected risks andare sufficiently liquid to be readily accessible.For example, in the United States, at its simplest, the minimum regulatorycapital requirement is stated as a measure of customer business (that is, the greaterof 4 percent of funds segregated on behalf of customers for domestic and foreigntransactions or $250,000). A firm capitalized at $250,000 of capital thus could carryaccounts for customers with net liquidating equities totaling $6,250,000. Assuming amargin level of 10 percent, positions with notional values of more than $60 millioncould be carried by that firm. Of course, regulatory capital requirements must be metwith assets that are haircut to reflect the potential cost and time to liquidate positions.Proprietary futures and written options positions are charged to capital at between100 and 200 percent of clearing margin, depending on whether the firm takingthe charge is a clearing member, a nonclearing member, or a nonmember firm.Therefore,proprietary positions in exchange-traded derivatives subject to regulation in theUnited States are valued for capital purposes based on the same model as that usedfor margin calculation, that is, a model that uses options pricing theory, nets specifiedpositions, uses proprietary formulas and assumptions for estimating and measuringvolatilities, and gives certain hedge and spread concessions. In the United States, allunsecured receivables must be discounted 100 percent.To the extent that portfolio margins are imprecise or backward-looking estimates,the capital requirement derived from margins shares these features. 48 Various48 These risk management measures have proved themselves overtime. But in modern circumstances, where tradingand clearing are decoupled, new or different models to ensure completion of transactions may be used (CPSS/IOSCO200I).Copyright © by the Inter-American Development Bank. All rights reserved.For more information visit our website: www.iadb.org/pub