Margin Accounts

Margin Account: collateral management

As with most trading relations; a key risk relates to credit risk or counterparty risk. How do we ensure that we are paid what we are owed. Banks, trading houses, merchants and mafiosi all similarly devise incentives that nudge us towards timely payment of outstanding debts. Legal and extra-judicial solutions are often introduced to encourage debtors to pay on time. Exchanges can only function if moneys owing are paid. If the risk of default is high exchanges are likely to lose profitable business and order flow. To remedy this risks exchanges typically impose margin requirements that demand collateral from traders. This introduces a skin in the game dynamic and a trader can not easily walk away from their obligation if a trading position turns negative. If two traders agree to buy/sell an asset in the future for a pre-determined price, the same risk applies. One of the traders may have second thoughts and try to back out. More typically, a counterparty simply may not have sufficient financial resources to honor the agreement.

One of the main objectives of the exchange is to organize trading so that contract defaults are obviated. The operation of margin accounts acts as the glue that binds counterparties and the exchange together and minimises this risk. Some amount of cash (or securities with a haircut) must be deposited at the time the contract is entered into. This is commonly referred to as the initial margin. At the end of each trading day, the margin account is adjusted to reflect the trader’s gain or loss. This is referred to as daily settlement or marking to market. In practice, many exchanges have moved to real time settlement. The variation margin or mark to market approach tracks the performance of each individual trader. Futures are marked-to-market. The profit or loss on the position is then appropriately credited/debited to/from the holder by the clearing house adjunct to the futures exchange. Additional margin or a margin call may be periodically necessary to top up or restore the credit quality of the counterparty. Thus if the value of the account falls below the maintenance margin, the counterparty must satisfy a margin call which restores the collateral to the value of the initial margin. Should this fail, the clearinghouse will take steps close out the position of the counterparty. Below, this is explained with reference to a numerical example set out by John C Hull.