In derivatives trading, initial margin is collateral exchanged at the beginning of the contract to protect a party from the possibility of default of its counterparty. Variation margin is another type of collateral, paid every day throughout the life of the contract by whichever side of the trade is losing to reflect the current market value of the trade.
Both initial margin and variation margin ensure both parties are adequately covered against potential losses.
Keep reading for a more comprehensive answer:
Let’s start from the beginning.
Initial margin and variation margin are collateral. That is it. That’s all they are. But what exactly is collateral?
Collateral is an item of value a lender can seize from a borrower if they fail to honor their financial obligations.
In response to the 2008 financial crisis, countries aimed to develop consistent global standards for non-centrally cleared OTC (Over-the-Counter) derivatives.
The goal was to reduce systemic risk by ensuring collateral is available to offset losses caused by the default of a counterparty in a derivatives contract.
To do this, firms were now required to exchange both variation margin and initial margin to mitigate counterparty credit risk.
While VM was already a standard feature in the OTC market, IM is fairly new.
Let’s see what these mean and what are the differences between them:
Initial Margin Definition
Initial margin (IM) is the collateral a counterparty pays to a bank to cover the risk it represents. The financial institution collects the amount right at the inception of the contract.
The goal is to protect the financial institution from the potential future exposure (PFE) resulting from the default of the counterparty it is selling the derivative to.
Initial margin covers those potential future losses.
Since 2016, large financial firms (essentially the largest banks and dealers) must post initial margin to each other when trading directly with each other (as opposed to through a central counterparty that sits in the middle of the trade).
For trades cleared through a central counterparty clearing house (CCP), firms post initial margin to the clearing house. In non-cleared trades, to each other. It is usually posted in the form of cash or government bonds.
Regulations do not allow netting the requested and the posted initial margin.
This means there’s no offsetting of opposing cash flow obligations between the two parties to transform it into a single cash flow from one firm to the other for the net amount. The result?
There are always two separate initial margin transfers between firms. In other words, there’s a bilateral exchange (each party both posts and receives margin).
Usually, the recipient of initial margin cannot reuse it for new investments. Instead, the amounts are segregated and go to a custodian who holds the posted collateral. Two counterparties can have different custodians.
IM is a well-established process for exchange-traded and cleared derivatives. But for non-centrally cleared OTC derivatives it is a fairly new process.
Now, how do you calculate initial margin?
Initial Margin Calculation
The most common way is to use the ISDA Standard Initial Margin Methodology (SIMM).
ISDA (International Swaps and Derivatives Association) developed this margin calculation methodology with the goal of reducing disputes, creating efficiency through netting of exposures, and allowing consistent regulatory oversight.
The ISDA SIMM suggests a Monte Carlo simulation to estimate a trade’s VaR (Value-at-Risk).
It goes roughly like this:
- Simulate thousands of future potential scenarios.
- Each scenario has random values for a set of risk factors that affect the total value of the portfolio. And these changes in portfolio valuation are recorded.
- Then you sort those valuations to see which ones cause the biggest losses.
The initial margin required is usually the sum of the top couple of losses, or a result selected according to the confidence interval wanted (usually 90-99%).
Market participants globally can use the SIMM. It eliminates the need for each firm to develop its own margin calculation methodology. Most large banks have adopted it.
The riskier the derivatives portfolio, the higher the initial margin the SIMM will suggest the bank demands from its counterparty.
Other than the SIMM, there’s also the standardized/grid-based approach.
Regulators defined this model and it is straightforward to implement. However, it leads to conservative initial margin requirements.
Under the grid method you determine initial margin by simply applying percentages to the notional of derivatives by product type and maturity.
The SIMM is more risk-sensitive than the grid-based approach, but also more complex.
Whether one model will yield savings in margin requirements over the other or not depends on the composition of the portfolio. But in general, the ISDA SIMM results in lower margin requirements.
Variation Margin In Derivatives
Variation Margin (VM) is the collateral exchanged every day to cover the mark-to-market change of an OTC derivatives contract.
Mark-to-market tells you how the fair value of an asset fluctuates every day. These daily mark-to-market valuations usually follow well-recognized industry calculation methodologies.
The daily exchange of VM reflects the profit or loss of each counterparty compared to the previous valuation of the financial instrument they trade.
This daily exchange mitigates counterparty risk. Why?
Because you always know where you stand in the trade, instead of waiting for the settlement date.
By then, the amount one party owes the other may be too much. And the loser of the trade may no longer be able to pay.
VM follows the value of the trade every day. And when the exposure is above the Minimum Transfer Amount (MTA), the loser of the trade at the time will post variation margin to the winner.
The MTA is a clause in the Credit Support Annex (CSA) that aims to avoid the inconvenience of transferring small amounts between trillion-dollar banks when exposure hasn’t changed a great deal overnight.
MTA is usually €500k, so it means VM is not actually traded religiously every single day between counterparties.
Under the CSA, there will usually also be a threshold up until which no collateral is required. Anything above that threshold and the MTA is variation margin to be paid.
Difference between Initial Margin and Variation Margin
Collateralization is a widely adopted practice in the OTC derivatives market, with initial margin and variation as the two main types of collateral.
Both have the main goal of protecting one party from the default of the other counterparty.
Initial margin is transferred between both ends of the deal at its inception.
Variation margin is transferred daily from one side of the trade to the other, to reflect the present value of the trade.
Initial margin protects both parties against the potential future exposure of the other. This exposure is a result of future fluctuations in the price of the underlying asset of the contract.
In contrast, variation margin protects both parties in a transaction from their current exposures.
A party only has exposure to the other if the market value of derivatives contract moved in its favor. The counterparty losing the trade at the time owes money, so they have no exposure.
The winner and loser of the trade can shift at any time, triggering variation margin payments from either participant of the trade. Hence why VM protects both parties.
VM ensures the current value of a derivative is collateralized. It has been a standard feature of the OTC market for a long time.
IM ensures there is a margin buffer to protect against losses following the default of a counterparty.
Say you’re a bank and your counterparty in a derivatives trade defaults. Initial margin serves as a buffer to protect you against negative changes in the value of the trade in the period between the last exchange of variation margin and the point at which you are able to hedge or replace the trade.
In other words, if the loser of a trade defaults before being able to pay what they owe, initial margin covers the potential losses that occur due to market fluctuations while the winner tries to hedge or replace the trade.
Initial margin is a risk-based calculation, while the variation margin calculation is based on the market values of trades.
Firms calculate variation margin based on the day-to-day valuation changes directly observable on the market. Initial margin on the other hand, depends on the choice of model and its assumptions.
They can use whatever model they want to calculate initial margin, as long as it meets certain criteria and gets regulatory approval.
Because of this, internal margin models may differ significantly, making it possible for two firms to get significantly different initial margin figures for the same trade.
The SIMM provides an open, transparent, standard methodology to help avoid disputes.
Initial Margin vs. Variation Margin Example
Let’s say you’re an asset manager looking to trade interest rate derivatives with a bank.
More specifically, you agree to an interest rate swap where you simultaneously pay a stream of cash flows based on a fixed interest rate and receive a stream of interest payments based on a floating rate.
Both payment streams are based on a given notional amount, and the interest payments are netted.
Based on your exposure to the bank and its risk profile, after using your internal model in line with the SIMM, you arrive at the initial margin the bank should post to you. The bank does the same.
You both agree to each other’s initial margin requirements and post the collateral to each other. Initial margin is posted when the trade is first executed.
This protects you while you try to liquidate/replace/hedge the trade in the event that the bank defaults.
After some time passes by, interest rates move.
The floating interest rate the bank pays you has increased, meaning you are winning the trade.
You are exposed to the bank and are facing a potential loss if they default and fail to pay what they owe you. If the value of the trade shifts in your favor far enough (above the MTA), the bank will transfer variation margin to you, reducing your exposure.
The same applies vice-versa. If the trade starts going in favor of the bank, you will have to post VM to them. They are now exposed to you.
This helps guarantee both parties have adequate collateral throughout the life of the trade.
Margin Requirements for Non-Centrally Cleared Derivatives FAQs
What is the difference between variation margin and initial margin?
Initial margin is collateral a firm collects/pays to reduce its future exposure to its counterparty in a non-cleared derivatives trade. On the flip side, variation margin is collateral exchanged every time one side of the trade loses too much value to reduce the exposure of the winning counterparty.
What is variation margin in ISDA?
In the CSA (part of an ISDA master agreement), variation margin means the collateral a counterparty collects to reflect the results of the daily marking-to-market of open OTC derivative contracts. This reduces the counterparty credit risk the winning counterparty is exposed to. Under the CSA, variation margin is only transferred if the MTM value a party is losing to the other is above a given threshold and the minimum transfer amount agreed upon.
When are you required to pay an initial margin?
Always, since 2015 under the BCBS/IOSCO framework. Initial margin is paid upfront and serves as an extra layer of protection against delays in getting rid of collateral in the case of counterparty default. Additionally, initial margin should be segregated (meaning paid to a custodian, as opposed to directly between counterparties) and cannot be reused for investment purposes.