A margin is collateral that the owner of a position in futures contracts, options, or other securities must deposit to cover the credit risk of his counterparty, a broker, or a clearinghouse member. Hence, the key role of margins is to make markets operationally smoother by limiting default risk. This risk can arise if the holder has completed any of the following:
- Entered into a futures contracts
- Sold securities (including derivatives) short
- Borrowed cash from the counterparty to buy securities
The amount that must be deposited at contract inception is called initial margin, or initial margin requirement. At the end of each day the margin account is adjusted to reflect the trader’s profit and loss: this is the mark-to-market mechanism.
There is a minimum amount, the maintenance margin, of collateral that must be maintained in a margin account, to ensure that the balance never becomes negative. this minimum amount is also referred to as minimum maintenance. This level is a minimum, and a number of brokerages have maintenance requirements lower than the initial margin.
Finally, the investor will receive a margin call if the value of the securities in the portfolio drops below the maintenance margin: the investor has to deposit extra-collateral, known as variation margin, to bring the account up to the required level. If this does not happen, the broker closes the position, limiting counterparty risk.
A number of market participants are involved in the margining process. Traders are required to maintain margin accounts with brokers. Brokers (if they are not clearinghouse members) are requested to maintain margins, called clearing margins, with members of the clearinghouse. The clearinghouse acts as an intermediary that settles trades and regulates delivery.
Portfolio margining is one of the most important financial safeguards, ensuring integrity to the system. In fact, the clearing service provider settles its accounts daily. As daily closing prices change the value of outstanding positions of each underlying or index in customers’ accounts, the clearing service provider collects margins from those who have lost money, and credits the funds to the accounts of the investor having made a profit.
Thus, prior to the start of each trading day, the entire amount of losses on the previous trading is collected and all profits are credited. Basically, a futures contract is closed out and rewritten each day, thus avoiding major losses.
In addition, many exchanges use real-time risk system in order to determine the margin requirement on the basis of the estimated risk in a customer’s portfolio, projecting the potential losses (e.g., estimating value at-risk and performing stress tests, often with sophisticate risk models) that could be created by various moves in the underlying equity or index markets.
Doing so, since portfolio margining accounts better reflect this actual market risk, these exchanges can require less equity on deposit, providing greater leverage to the investors.