Clearing, margin and collateral · RiskAtoms Academy

Know these first

L1.7.03 Futures and margining
L1.2.07 Central counterparties and market utilities
L1.6.04 Repo and securities financing

By the end you will be able to

1Describe the post-2008 reforms of OTC derivatives and the margin requirements they introduced.
2Explain how a CCP reduces risk through novation, netting, margin and a default waterfall.
3Work out how much collateral to post once haircuts are applied.
4Explain how margin can create liquidity strain in a crisis.

Why it matters

When Lehman Brothers failed in September 2008, it was a party to hundreds of thousands of derivatives contracts, and nobody outside could see the full web of who owed whom. A year later the G20 leaders set out to make that web visible, collateralised and, where possible, run through a central hub.

Core explanation

From a tangled web to a hub

Before 2008, most OTC derivatives were bilateral: two firms, one contract, often with little or no collateral, and no central record. That had three problems. Exposures were hidden, losses could spread from firm to firm, and a big seller of protection could run up huge obligations without posting anything to back them.

The G20 commitments, Pittsburgh, September 2009

Standardised OTC derivatives to be traded on exchanges or electronic platforms where appropriate, and cleared through central counterparties.
All OTC derivatives contracts to be reported to trade repositories.
Contracts that are not centrally cleared to face higher capital requirements. In 2011 the G20 added margin requirements for them too.

These commitments became law in the US through the Dodd-Frank Act of 2010 and in the EU through EMIR, the European Market Infrastructure Regulation of 2012, with similar rules in Japan, the UK, Australia and elsewhere.

What a CCP does

A central counterparty (L1.2.07) steps into every trade it clears through novation: the contract between two banks is replaced by two contracts, each with the CCP. That brings four protections:

Multilateral netting. Each member has one net position against the CCP instead of many against each other. Netting shrinks what is at risk, as the diagram below shows.
Margin. Variation margin settles gains and losses daily, as with futures (L1.7.03). Initial margin covers the loss the CCP could suffer closing out a defaulter's positions.
A default fund. Every member contributes to a default fund, a shared buffer for losses larger than one member's margin.
A default waterfall. A fixed order for using these resources, the default waterfall, so that the defaulter pays first.

Four dealers, one set of trades

Settled

All trades, gross280

Owed after netting each pair220

Owed through the CCP20

USD millions. Arrows point from the side that owes to the side that is owed.

Margin for trades that are not cleared

Many derivatives are too tailored to clear. For these, the Basel Committee and IOSCO agreed a global framework for margin between financial firms and large non-financial groups, phased in from 2016 to 2022:

	Variation margin	Initial margin
Paid	Daily, as values change	At the start, and topped up as risk changes
Direction	Loser pays winner	Both sides post to each other
Held	Can be used by the receiver	Segregated, safe if the holder fails
Who	Covered firms trading uncleared derivatives	Firms with large uncleared books

Collateral and haircuts. Margin is paid in collateral: usually cash for variation margin, and cash or high-quality bonds for initial margin. Because a bond's price could fall before a defaulter's collateral can be sold, the receiver counts it at less than its market value. That cut is the haircut, as in repo (L1.6.04). Initial margin must be held under segregation, so it is protected if the firm holding it fails.

The price of safety. Margin moves losses to winners every day, so no one can build up an unpaid loss. But margin calls must be paid in cash, fast. In a sharp market move, firms that are well hedged on paper can still be forced to sell assets to raise cash, which can push prices further.

Try it

A clearing member defaults. The CCP closes out its positions at a loss. Slide the size of that loss and watch it eat through the waterfall, layer by layer.

Try itThe default waterfall

Loss on the defaulter's positions, after closing them outUSD 260m

1Defaulter's initial margin150 of 150
2Defaulter's default fund contribution50 of 50
3CCP's own capital (skin in the game)25 of 25
4Other members' default fund35 of 300

Surviving members now share the loss through the default fund. They have paid for someone else's failure.

Layer sizes are illustrative, in USD millions.

Worked example

Posting initial margin with a haircut

A hedge fund must post USD 10m of initial margin to its dealer on an uncleared swap. It can post cash, government bonds with a 2% haircut, or shares with a 15% haircut. Haircuts here are illustrative.

How much collateral?

Step 1 of 5

1
Cash
No haircut: USD 10.00m.

Regulatory lens

The rules in force: in the US, Title VII of the Dodd-Frank Act (CFTC for swaps, SEC for security-based swaps); in the EU, EMIR, with clearing obligations for standard interest rate and index CDS contracts; worldwide, the BCBS-IOSCO margin framework for uncleared derivatives and the CPMI-IOSCO Principles for Financial Market Infrastructures for CCPs. Basel capital rules reward clearing: trade exposures to a qualifying CCP carry a 2% risk weight, far below most bilateral exposures. Later levels cover counterparty credit risk capital in detail.

Sparks

SparkWhen safe hedges needed cash: UK pensions, 2022

In late September 2022, UK government bond yields jumped sharply after the government's fiscal announcement. Pension funds using liability-driven investment (LDI) strategies faced large collateral calls on their interest rate hedges and had to sell gilts to raise cash, pushing yields higher still. The Bank of England stepped in on 28 September with temporary purchases of long-dated gilts.

SparkA CCP is a concentration of risk

Clearing turns a web into a hub, which makes the hub itself critical. That is why CCPs face their own strict rules, stress tests, and recovery and resolution plans: a failing CCP would hit all its members at once.

Key takeaways

After 2008 the G20 agreed central clearing of standard OTC derivatives, reporting of all trades, and higher capital and margin for uncleared ones.
A CCP novates trades, nets them multilaterally, collects margin, and holds a default fund.
The default waterfall makes the defaulter pay first, then the CCP, then the surviving members.
Uncleared trades between large firms need daily variation margin and two-way, segregated initial margin.
Collateral is counted after a haircut: market value needed = amount ÷ (1 − haircut).
Margin makes the system safer but can create sudden needs for cash in a crisis.

Reaction

Check what stuck

Question 1 · objective 1

Which of these was a G20 commitment in 2009 for OTC derivatives?

ABan all OTC derivativesBClear standardised OTC derivatives through central counterpartiesCMove all derivatives to a single global exchangeDRemove margin from derivatives to cut costs

Question 2 · objective 3

You must post USD 20m of initial margin. The receiver applies a 4% haircut to the government bonds you post. What market value of bonds must you post, in USD millions, to two decimal places?

USD m

Question 3 · objective 2

Through a CCP, Bank A is owed 30 on its trades with B and 10 on its trades with D, and owes 50 on its trades with C. How much does A owe the CCP, net?

Question 4 · objective 2

A member defaults and closing out its positions loses USD 260m. Its initial margin is 150m, its default fund contribution 50m and the CCP's own capital in the waterfall 25m. How much falls on the other members' default fund, in USD millions?

USD m

Question 5 · objective 4

Why can margin requirements themselves cause stress in a market crash?

ABecause margin is a tax collected by governmentsBBecause large price moves trigger large variation margin calls that must be paid in cash at short noticeCBecause CCPs stop collecting margin in a crashDBecause collateral cannot be posted in government bonds

Glossary

Central counterparty: Central counterparty: a clearing house that becomes the buyer to every seller and the seller to every buyer.
Novation: Replacing one contract with two: each original party now faces the CCP instead of the other.
Netting: Offsetting what you owe against what you are owed, so that only the difference is at risk.
Trade repository: A database that collects details of derivatives trades so that supervisors can see who holds what.
Initial margin: Collateral posted at the start to cover the loss a counterparty could cause if it defaulted and its trades had to be replaced.
Variation margin: Collateral paid every day to cover the change in a contract's market value.
Default fund: A pool every clearing member pays into, used to cover a member's default once its own margin is used up.
Default waterfall: The order in which a CCP uses its resources to cover the losses from a member's default.
Collateral: Assets pledged to secure an obligation. If the poster defaults, the receiver keeps them.
Haircut: A cut in the value given to collateral, to allow for its price falling before it can be sold.
Segregation: Holding posted collateral apart from the receiver's own assets, so it is safe if the receiver fails.

Deep Dives & Origins

Deep Dives

Jon Gregory, Central Counterparties: Mandatory Central Clearing and Initial Margin Requirements for OTC Derivatives (Wiley, 2014). Intermediate.
Financial Stability Board, OTC Derivatives Market Reforms: Implementation progress (annual reports). Beginner.

Origins

G20 Leaders' Statement, The Pittsburgh Summit, 24–25 September 2009.
BCBS and IOSCO, Margin requirements for non-centrally cleared derivatives, BIS, 2013, revised 2015, 2019 and 2020.
Regulation (EU) No 648/2012 on OTC derivatives, central counterparties and trade repositories (EMIR).
Dodd-Frank Wall Street Reform and Consumer Protection Act, 2010, Title VII.
Bank of England, Financial Stability Report, December 2022.

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Credit default swaps

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Derivatives disasters and their lessons