plus dividend payouts). Notably, buyer’s cash flows can be negative depending on underlying
performance.
Despite being part of the non-cleared market segment and traded OTC, equity swaps are
typically fully collateralized and require both, initial and variation margin, which is a usual
practice among broker banks rather than a regulatory constraint.
9
Variation margin (VM)
covers changes in the contract value, while initial margin (IM) is required at execution and
constitute the margin account. Similarly to most contracts, which require initial margin to
reflect the potential loss over 2 to 10 days in a tail event, depending on broker agreement,
the initial margin for equity swaps can be static or dynamic and reflects the tail risk of
the overall portfolio. For a non-model based IM, EMIR allows 15 % flat rate for equity
derivatives
10
which is applicable to a total portfolio notional. This standard schedule was
slightly adjusted to take into account net-to-gross ratio, which is applicable to netting sets
(see Annex IV of EU2016/2251 (2016)).
1.4 Leveraged trading and overlapping portfolios
The fact that equity swaps are traded on margin accounts makes these instruments very ap-
pealing for clients that aim to build synthetic leverage. By entering an equity swap, clients
obtain synthetic exposure to the underlying stocks without owning them. This exposure is
leveraged as clients pay only a fraction of the notional value into the margin account (see
Figure 4 for a schematic representation). However, not all equity swap positions found in
the EMIR data can be attributed to synthetic leverage. To assess the leverage of market
participants (non-banks), the derivative (synthetic) positions would need to be linked with
on-balance sheet positions to see how derivatives positions are used - to gain synthetic expo-
sure or to hedge. For hedging purposes, market participants (bank clients) would need to sell
equity swap contracts in order to have a delta neutral exposure against their stock holdings
and the market value of their derivative exposures would increase (rather than decrease) in
case of falling stock prices, which would not result in an additional liquidity pressure. This
paper emphasizes the opposite situation - when market participants use brokerage services
to buy the equity swap contracts, this way obtaining the synthetic exposure.
In general, clients need to replenish their margin account when market moves against
them, by using either cash or HQLA securities. Depending on broker agreement, positions
9
For market participants (financial counterparties and non-financial counterparties that exceed the clearing
threshold pursuant to Article 4a or 10 of EMIR) with a nominal volume of non-centrally cleared OTC derivatives
of more than € 3 billion at group level, the obligation to exchange initial and variation margins started on
4 February 2017. The requirement to exchange initial margins will apply to counterparties with an aggregate
average notional amount exceeding EUR 8 bln starting 1st Sep 2022, current threshold is EUR 50 bln.
10
The rate varies per asset class, for Interest rate derivatives it is between 1% to 4%, Credit 2% to 10% (in
both cases depending on the maturity of the contracts), 10% for Commodities and 6% for FX.
ECB Working Paper Series No 2722 / September 2022