Why Does Exposure Matter?

Firms like to make profits, and they don't like making losses.

If your counterparty goes bust, how much have you got to lose? One measure is Variation Margin, meaning the value of the portfolio last night. Another is the initial margin which forecasts what your portfolio might be worth in the future.

Initial Margin gives you foresight which a firm can use to take steps to cover that exposure. Taking delivery of assets to cover the IM will offset losses in a default.

The amount of initial margin is a strong indicator of the amount of risk in a portfolio. IM also indicates the amount of risk in a whole firm.

Regulators wish to mitigate the effects of a future crisis by requiring firms to measure and cover Initial Margin. This seems a sensible move as it links increased risk to increased cover Initial Margin. In theory this makes the OTC market a safer place than before 2008.

Avoiding a build-up of risk in any banking market is a goal for regulators. Governments don't want to bail out any more banks, leading to the new regulations attempt to prevent that outcome going forward. 

Systemic Risk

The capital markets are a globally inter-connected system which defies modelling even more than weather. Think of the interactions and linkages between the FX markets, bonds, equities and derivatives - directly or indirectly they all need each other to function normally.

Regulators learned from the GFC that risk in one market can have an effect in another. For instance a default in OTC derivatives will require firms to sell of bonds held as collateral. If the effect of the default is to destabilise the bond market then price volatility may mean the recovery value is below usual market levels, meaning losses for the surviving firms.

By requiring a direct connection between risk in OTC derivatives and holding IM to cover these, regulators aim to make the market self-balancing as risk taking means placing more IM which requires funding and ultimately should reflect back on the trader or desk taking the positions. Should a default occur, the IM assets should help offset losses.

Regulators see themselves as guardians of the global capital markets 'system' as they will all be held accountable should the flow of money cease and cause widespread harm to national economies and people like you and me.