Margin and Clearing on Exchanges

Futures Exchanges Guaranty Contract Performance

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A futures exchange is a hub where consumers, producers, traders, arbitrageurs, speculators, and investors come to trade standardized futures contracts. A futures contract is a contract that represents specific quantities of a specific grade of a commodity or financial instrument with a delivery date set at a specified time in the future.

Buyers and sellers of futures contracts come together at the exchange, which is a transparent marketplace where those market participants establish fair prices based on current market conditions. The current price of a futures contract is the latest price where buyers and sellers have agreed to transact. Therefore, futures exchanges establish transparent market prices on a real-time basis.

Success Depends on Buyers and Sellers Meeting Mutual Obligations

The success of a futures market depends on the confidence that buyers and sellers meet their mutual obligations. Each futures exchange has a clearinghouse. The clearinghouse guarantees that both parties, the buyer, and the seller, perform on the contracts that they trade.

Unlike other types of transactions where a buyer purchases from a seller and each depends on the other for performance, on a futures exchange it is the clearinghouse that becomes the contract partner of each party to the transaction once executed.

Therefore, there is no credit risk between the buyer and seller- each looks to the clearinghouse for performance. The exchange charges a small fee on each contract traded in order to support the administration of the clearinghouse.

Two Types of Margin

In order to make sure of performance on each futures position, the clearinghouse requires buyers and sellers who open new positions to post margin. Margin is a good faith performance deposit. There are two types of margin, original margin (sometimes referred to as an initial margin) and variation margin (sometimes referred to as maintenance margin). Margin ensures that if the price moves against a buyer or seller that the party has enough money to cover those losses. Margin can be in the form of cash or negotiable and liquid securities.

When a buyer or seller opens a new position on a futures contract, the party is required to post original (initial) margin. Original (initial) margin requirements are higher than variation (maintenance) margin requirements. The later comes into play when the amount of original margin posted drops below the variation margin level. When this occurs, the party is required to add more margin immediately. Let us look at an example for a buyer of one CME/COMEX gold futures contract:

  • Gold price- $1180 per ounce
  • Each contract represents 100 ounces
  • Original/Initial Margin requirement: $6,600 per contract
  • Variation/Maintenance Margin requirement: $6,000 per contract
  • A buyer at $1180 must immediately post $6,600
  • If gold falls below $1174 (a $600 loss) the buyer must add more margin

In theory, this system ensures there will be enough resources available for buyers and sellers to meet their obligations. Futures prices can be very volatile so there may be more than one margin calls in a day.

The futures exchange itself is responsible for setting margin requirements. When prices become more volatile, an exchange will often raise margin requirements in order to account for the added risk of wider daily price ranges. Conversely, when volatility in a particular market decreases exchanges will adjust the amount of margin required to trade lower to reflect the lower risk.

Margin Levels Reflect Volatility

Margin levels reflect volatility and markets that are more volatile require more margin as a percentage of total contract value. In the gold example the original margin required is only 5.6% of total contract value ($1180 times 100 ounces per contract=$118,000---$6,600/$118,000= 5.6%).

Therefore, a buyer or seller only has to post 5.6% of the total contract value to control a full contract of gold. Futures market offer tremendous leverage to buyers and sellers. Of course, more volatile futures contracts will require more margin on a percentage basis. Natural gas futures currently require approximately 7% original margin reflecting the higher volatility of natural gas prices.

Clearinghouses serve as the contracting party to buyers and sellers on futures exchanges. Margin protects the clearinghouse from losses and ensures that buyers and sellers fulfill their obligations.

Update on Margin and Clearing

While margin is at a certain level for individual futures or commodity contracts, those who do not trade outright long or short positions will often see different margin levels against their positions. For example, intra-commodity spreads, or a long position in one month against a short position in another month of the same commodity or future often receive treatment that is more favorable when it comes to margins.

The margins for these term structure spreads are lower than for outright long or short positions in any one month. Additionally, inter-commodity spreads or a position that is long one commodity against a short in another related commodity often has a lower margin than the sum of the outright margin requirements for either commodity. This is because the exchanges use a SPAN system. SPAN uses a sophisticated set of algorithms that determine margin taking into account the total daily exposure of a trader's portfolio rather than each specific position.

Exchanges are responsible for margin levels. They can change at any time because sometimes market prices are volatile and at others, they are not. When an exchange suddenly changes the margin requirement for a futures contract it can trigger a move in the price of the market.

This happened in April and May of 2011 when the COMEX division of the CME raised the margin on silver when it traded to highs just under $50 per ounce. The rise in margin caused some market participants to close long positions, which added to a huge downside move in the price of silver at that time.

Margin is an important concept for traders to understand as it can influence prices. Margin is the mechanism that guarantees that a clearinghouse can meet obligations to all market participants.