CFM13070 | Understanding corporate finance: derivatives: margin payments on exchange-traded contracts

Exchange-traded contracts: margin payments

If company A wants to sell a certain number of exchange-traded futures contracts and company B wants to buy, each company executes a contract with the clearing house, not with each other.

In reality, the clearing house will only do business with a limited number of high quality counterparties, the clearing members of the exchange. These clearing members will deal as principal with the non-clearing members of the exchange. The non-clearing members may be dealing on their own account, or as agent for their own external customers.

An end customer will put up margin with a dealer, the dealer with a clearing member of the exchange and the clearing member with the central counterparty. There will typically be an initial margin put up on entry into the contract supplemented by a variation margin (which varies over time) sufficient to cover the extent that the contract is ‘out of the money’, that is to say the amount that would need to be paid to settle the contract.

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Arrangements have to be made for the payment of collateral or ensuring the performance of the contract along the whole length of the chain. The clearing house, although it has a vital role in that function, only guarantees the performance of a contract between the two clearing members in the middle of the chain.

Each of the two clearing members must put up a collateral deposit with the clearing house. Such deposits will have been provided by the ultimate customers, but are nonetheless paid by the clearing members as principal.

Each clearing member will maintains a minimum amount in its margin account calculated according to the clearing house’s rules. For a single contract, the minimum amount will have to exceed the initial margin for that contract. The amount of the initial margin is intended to protect the clearing house against the risk of loss from price movements from the previous day’s closing price to the time when it can close out the position of a defaulter.

An individual clearing member will, of course, have positions in a great many contracts with the clearing house at any one time. These will include contracts to buy and to sell exchange-traded assets, but initial margin is required for both types of contract.

At the end of the day, each open position on the exchange is marked to market using the day’s official settlement price. This results in the calculation of daily ‘variation margin’ - amounts which are added to or subtracted from the previous day’s minimum required amount. If the counterparty has made a profit, the minimum required amount is reduced by that profit. If the counterparty has made a loss, the minimum required amount is increased by the amount of the loss.

If this results in the margin account balance falling below the minimum required amount, the clearing member will need to contribute further cash or other acceptable collateral (a ‘margin call’). The clearing house will automatically close out some or all of the contracts if the additional collateral is not forthcoming.

Whether or not there is a daily profit or loss depends on both the increase or decrease in the price of the asset concerned and on whether the counterparty is buying (taking a long position) or selling (short).

The arrangements for calculating margin payments for exchange-traded options are more complex than for futures, but the underlying principles are similar. The clearing house will need collateral to cover both initial margin requirements and daily movements in variation margin due to marking to market.