Central clearing counterparties or CCPs play an essential role in mitigating counterparty credit risk in derivatives trading, and are a standard practice for exchange traded derivatives and increasingly common in the over the counter markets as well. Upon execution of a trade, the CCP places itself between the contracting parties, assuming the role of buyer to the original seller in that first contract and of seller to the buyer in the original contract agreed over the exchange, thus guaranteeing the performance of the contract to one counterparty should the other default.
This significantly reduces counterparty credit risk for both of the original parties.
CCPs ensure their ability to perform these guarantees by implementing a robust margin system typically comprising of two key elements. Initial margin or IM and variation margin of VM. Initial margin is an amount of money that both the long and short side of a contract have to deposit with the central counterparty on the day that they enter into a derivatives trade. Variation margin requires that any losses suffered by either side are paid to the CCP on a daily basis with gains being received from the CCP on a daily basis as well. It's a straightforward, yet vital mechanism. It functions to ensure that the collateral backing of position remains sufficient throughout the contract's duration.
This daily settlement of profits and losses reflects the changing market value of open positions.
Although this is typically done at the end of a trading day based on closing prices, intraday margin calls are possible. If markets experience substantial price movements, consider the following example to illustrate the process.
Two counterparties A and B engage in a futures contract through an exchange. Counterparty A buys one contract, and B takes the other side selling one contract, both opening new positions at a futures price of 5,000.
Assuming each index point has a value in a futures contract of $50, let's assume that there is an initial margin requirement of $13,000 per contract after the trade has been entered into both A and B are obligated to post the initial margin of $13,000 to the CCP. On each day throughout the life of the contract. The CCP will calculate the variation margin based on price movements. Let's see what happens if at the end of the first day the future's price closes at 4,995. counterparty A will have incurred an unrealized loss of $250 per contract. That's for a five index point movement at $50 per point, which they must transfer to the CCP as variation margin. Counterparty B on the other hand, has enjoyed an unrealized profit of the same amount and receives 250 in variation margin from the CCP.
This process will take place at the end of each day ensuring continuous collateral adjustment and minimizing exposure to counterparty credit risk throughout the contract's life. On day two, if the future's price declines by further 10 points counterparty A must transfer an additional 500 in variation margin to the CCP and conversely, counterparty B will receive 500. But what is the role of the initial margin? Initial margin becomes critical in scenarios of default. If on day three there is a slump in market prices causing futures prices to drop a further 100 points and counterparty aid defaults unable to make the required $5,000 variation margin payment, the CCP still owes counterparty B, the variation margin for the gain that they've made. However, the CCP does not incur a loss because it has 13,000 in initial margin from a, which it now uses to fulfill the variation margin payment to B counterparty A's position is subsequently closed and the CCP does not suffer any losses and remains whole.
The initial margin thus acts as a safeguard, a buffer against possible losses that the CCP might suffer. Determined that trade inception and reflective of the potential one day volatility of the underlying asset. On closing of the future's position, the initial margin is returned by the CCP.
It's important to recognize that terminology and minor technical specifications may vary across different CCPs. Many exchange traded derivatives also define a maintenance margin, which is set below the initial margin level and is a balance below which the margin account must not fall, and signals when additional funds are required to restore the margin account to the initial margin level. This maintenance margin offers an extra layer of protection. Further fundamental principles of the margin system remain universally applicable.
