Cian O’Neill and Nicholas Vause.
Certain policy actions require a high level of precision to be successful. In a recent paper, we find that using margins on derivative trades as a macroprudential tool would require such precision. Such a policy could force derivative users to hold more liquid assets. This would help them to meet larger margin calls and avoid fire-selling their derivatives, which could affect other market participants by moving prices. We find that perfect calibration of such a policy would completely eliminate this fire-sale externality and achieve the best possible outcome, while simple rules are almost as effective. However, calibration errors in any rule could amplify fire-sales and leave the financial system worse off than if there had been no policy at all.Continue reading