If two investors are striking a deal to trade an asset in the future for a certain price, there are obvious risks. One of the investors can "disappear" or simply step back on his commitments in some way. Alternatively, the investor can be out of funds to honor the agreement. If the deal was agreed directly between two investors, on the Over The Counter (OTC) market, the both are carrying all these risks. Another, more secured option, is to strike the same deal on the organized exchange market, whose key role is to avoid defaults. Natural question would be, why don't we use the second option only? Even more surprising is the fact that the most of such trades are still done on the OTC market. Something goes wrong here, isn't it? In fact no, in order to secure trading, the exchange requires all participants to post a certain amount of money aside. So investors have to pay when the contract is signed on the organized exchange, while on the OTC market they have not to do that. For the most of investors "have to pay" means less money to invest elsewhere => less exciting. In this article we will examine the way how the deals on the organized exchange are regulated.
Daily Settlement and Margins
As usually we are going to take an example to illustrate how the things are fitting together. Let's consider an investor who calls its broker to buy 2 December oil futures contracts. Let current future price is 100 USD per barrel. To simplify we consider that contract size is 1 barrel. So our investor has contracted 2 barrels at this price for a total amount of 200 USD. To secure the transaction the broker will require to post an initial margin of 50 USD (25% of the contract amount). This amount will be deposited in a margin account, managed by the broker. So at the time contract is signed the investor have to pay 50 USD to its broker.
The price of the oil is fluctuating through trading days, so the price of the barrel tomorrow won't be the same as it is today. Obviously the price of the contract will follow this price change. At the end of each trading day, the margin account is adjusted to reflect the investor's gain or loss. This practice is referred to as daily settlement or marking to market. If barrel price decreased by 4 USD then 4 x 2 = 8 USD will be withdrawn from the margin account and it will pass to 42 USD from initial 50 USD. If next day the price of the barrel would rebound of 3 USD, then the margin account would rise back to 48 USD.
But what would happen if the barrel price falls drastically? In this case we are facing a risk that the margin account could become negative and obviously it is not something that exchange would accept. To avoid such a situation maintenance margin comes into play. Maintenance margin is lower than initial margin and it serves to define some kind of red line to the investor. Once this red line is reached the broker asks investor to top up its margin account to bring it back to the initial margin level (50 USD in our example). Let's imagine that that broker defined a maintenance margin as 80% of the initial margin or 40 USD. So if barrel's price falls by 5 USD or more the broker will ask investor to top up his margin account by 10 USD (or more) to return back to 50 USD account. In this situation the investor has to pay again.
Basically that's it.... This is how the exchange is regulating future contract deals.
Clearing
All this process is pretty straightforward and hopefully is clear at this stage. Broker is strongly involved into the settlement process, but what happens if broker itself fails to meet its commitments ? Indeed broker is just a financial company that can be solid and strong but also weak and fragile. The latter characteristics are not acceptable for futures trading supervision. This is a reason why clearing houses where created. Clearing house is an intermediary in futures transactions. It has a number of clearing house members or clearing brokers, who must post funds with the clearing house. Brokers who are not members themselves must channel their business through a member. So we have some kind of chain where investor is required to maintain a margin account with a broker, broker - with a clearing house member and finally clearing house member - with the clearing house:
Investor => Broker => Clearing House Member => Clearing House
If investors deals with a broker who is already a member then this chain simplifies by one layer. As clearing house member maintain a margin account at the clearing house then clearing house can require to top up its account if it reaches some level considered as dangerous. This process is known as a clearing margin. This works in the same way as between investor and its broker; the only difference that there is no maintenance margin on this level. Indeed every day the account balance for each contract must be maintained at an amount equal to the original margin.
Netting
In determining clearance margins, the clearing house calculates the number of contracts outstanding on either gross or net basis. Suppose a clearing house member has 2 clients : one with a long position in 20 contracts, the other with a short position in 15 equivalent contracts. Gross margin would calculate clearing margin on the basis of 35 contracts; net margining would calculate on the basis of only 5 contracts. Basically long and short positions are mutually compensating. Most exchange currently use net margining.
Conclusion
The level of margin can sometimes be used as a tool to control futures market activity. Lower margin levels would allow speculators to to take larger positions with the same amount of money being put aside. On the other hand higher margin levels are likely to make debt based speculation less attractive. For example in mid-2008 the oil prices reached historical levels due to derivatives speculation. These prices were undermining the real economy and I don't still understand why regulators didn't use this tool to take control over the speculation wave.
