Procyclicality and how the FED Broke the System

First off, this is not financial advice and I am nothing but a smooth brained ape who happened across some information to share. I do not have a financial background so take from it what you will.

This information is based on a report created by LCH. This is a clearing house used by Citadel and they are a market leader in risk management of derivative, margin, etc.

First, lets define Procyclicality. Beside being hard to spell, Procyclicality is the idea by which margin requirements fluctuate based on financial system stress. In an unstressed system there is less inherent risk to a position and margin requirements can be loosened. In a stressed condition the risk of a position going belly up is higher and thus stricter margin requirments are needed. We have already seen this with GME and AMC as the margin requirements to short have gone up significantly as the financial system has been more stressed.

While this is a normal part of the market function it there is some serious risk to the overal health of the financial system if external forces intervine. " procyclicality refers to components of CCPs’ initial margin models that generate greater directional fluctuations of all margin and collateral intake, especially during periods of market volatility. Such actions could have the unintended effect of exacerbating a financial crisis"

This is where the government comes in and does its thing. In April of 2020 the Federal Reserve Board made a temporary adjustment to the Supplemental Leverage Ratio (SLR). For background on SLR and the temporary change go here. Essentially SLR mandates banks hold 3% of their total assets as liquid collateral against their leveraged positions, the temporary changed lowered this to 1%.

From the LCH report "...natural response to increasing market volatility is to call 1) increased collateral against existing positions to provide a prescribed buffer against market moves, and 2) additional collateral associated with new positions brought on by increased trades, including activity driven to manage additional risk in periods of market distress."

So what did this FED action do to the procyclicality of the market? Well we were in a time of sever financial and economic uncertainty. Nearly all assets were under significant stress and it was on a global scale. Procyclicalty would predict an increase in margin requirements as the volitility in the market increases and assets come under stress. But the FED said "No no no, this machine needs to keep moving" and with swish and a flick of their magic wand all that liquidity the banks had been saving since SLR went in place in 2010 was barfed into the market.

As an analogy, imagine the government came out and said "Speed limits stay the same, but we will only pull you over if you go >20 mph over the limit." Does it mean its a good idea to go 45 in a school zone? Probably not. Does it mean people are gonna do it because they can get away with it? Absolutly.

And thats what happened nearly to the day that this rule change was annouced the market bounced off the bottom and shot off at a growth pace unseen in the last 20 years. Everyone started speeding.

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DOW Jones 5 Year Chart

With no brakes on the car everyone started taking on more and more leverage and with that they could take on risky positions like creating massive amounts of fake shares to short sell a company into bankruptcy.

We all know what happens then, so lets fast forward to March 2021.

On March 31st the SLR temporary rule expired and now all financial institutions with >$250 billion in assets must now hold 3%. Well guess what, all that leverage they took on over the course of 2020 now counts. How much did it increase? Well Bank of America for example had its year to year liabilitys growth increase from 3.83% in Dec 2019 to17.4% in Dec 2020. This meant these banks now need to carry not just 2x the liquid assets but 3x the liquid assets after the temporary SLR change ended.

To continue picking on BOA, this new capital requirement falls on a company that has had declining operating income for at least the last 4 years.

SPECULATION: I believe BOA was not the only bank struggling in recent years, I would love to get other apes to help check this out. I would wager they saw this temporary SLR change as their chance to take some risks and get caught back up while the market was hot. Maybe even work with some market makers to go all in on some slam dunk bets of GME going bankrupt?

What was that quote again? " Such actions could have the unintended effect of exacerbating a financial crisis"

So here is a financial crisis for you. How about a couple of stocks shorted higher than the float that a bunch of apes mistook for a banana sale and put all their tendies in the pot catching half the market with their pants down? Is that a good time to jerk around the procyclicality of he system? The FED throught so (good for us).

"...risk-mitigating actions that are excessively procyclical are undesirable both from a narrow risk management perspective, as well as from a macroeconomic and financial stability perspective. Risk management actions will be ineffective if they create greater systemic risk because of feedback loops."

It doesn't seem like the FED really understood the gravity of the situation and when they ended the SLR temproary rule it threw the markets into chaos and when we look back will be the single biggest catalyst for the squeeze.

So what is this feedback loop they mention? "Requiring more collateral during times of stress generates a run on collateral"

Here is the loop:

1. Increase Margin Requirements
2. Institutions convert non-liquid investments to liquid investments (they sell stuff)
3. Increased selling lowers the value of long positions, closing shorts lower the value of short positions owned by themselves and other entities
4. Higher Liabilities (due to decreased position value) = Higher Margin Requirements
5. See #2

We are currently in this loop set forth by the FED's removal of the temporary SLR rule. We have seen forced liquidiations, bond sales, crypto manipulation, etc. all in a mad dash to secure one thing, liquid assets for margin requirements.

Now under normal circumstances this is difficult for them but there is an extra problem, a giant sleeping gorilla is sitting right in the middle of the room.

We see all these liquidity moves all over the place, lots of...*creative* solutions to come up with cash when they could easily just close their shorts on GME, AMC, etc. and massivly reduce one of their biggest liabilities. So the question is, why are they tiptoing around their biggest liabilities doing legally dubious stuff instead of just eating a portion of the loss and moving on?

Because they know if they poke that gorilla they know it isn't going to move nicely, its gonna grab every last tendie, their wife's boyfriend, and hop on a rocket to outer space.

These guys arn't dumb, so how are they trying to limit the feeback loop from getting out of control (SCH specifically not representative of the whole market)?

"An individual member’s financial resource requirements should not jump too significantly (by more than 25%) over the MPOR at any point in the hypothetical future generated by a replay of history covering a previous crisis."

If you are like me you think, wtf is MPOR. Margin Period of Risk (MPOR) is also known as the "liquidation period" stands for the time period from the most recent exchange of collateral covering a netting set of financial instruments with a defaulting counterparty until the financial instruments are closed out and the resulting market risk is re-hedged. In smooth brain terms, it the time from when you take on the debt until you close out the debt or you default.

So market models are operating on the assumption that margin requirements should not rise by more than 25%... but both the SLR change and the GME/AMC change is a lot more than 25%. Simply put, these guys are absolutly not ready for this kind of volitile change in margin requirements. SLR=200% change and GME/AMC shorts=200% change. SPECULATION: If you wanna know why these guys are working on the weekends, its to figure out exactly how they are going to come up with the cash without punching each other and themselves in the face by driving down the value of their other assets. It is an incredibly complex balancing act they are doing in unison to make sure eveyone has enough money and nobody is getting stressed to the point they get the call from margin. And if one of them goes down, its a house of cards.

SPECULATION: My last point. A few days back we got news of JP Morgan (and others) opening "Netting Accounts." If you wanted to take a bunch of margin from different counterparties and reset the MPOR so you could increase the margin requirements >25% to minimize your exposure to a catastrophic event this wouldn't be a bad way to do it.

If you have the time read this paper, very enlightening. It has a ton of info on how clearning houses assess risk and allocate margin.

TLDR: The ending of the SLR temporary rate may have been THE catalyst for the squeeze. Hedgies and banks are trying to figure out how to raise money while keeping GME and AMC from mooning and from crashing one another. If they make one miscalculation and margin requirements cannot be covered by all parties holding GME and AMC shorts a cascade of margin calls can occur initiating the MOASS.