In order to guarantee the duties of a clearing house, market participants need to arrange for a guarantee for each position, for instance, being commodity (derivatives) contract. Such a guarantee is called ‘collateral’. Various objects could be used as collateral, including a bar of gold, a portfolio of governmental bonds, a bundle of corporate shares or a bank guarantee. An alternative concerns cash. To be precise, a cash collateral is called ‘margin’. A system of margining is normally operated by clearing organisations, such as central counterparties.
The total amount of margin which a clearing organisation calls for (by initiating a so-called ‘margin call’) is composed of initial margin, to be deposited as soon as a deal is concluded and, possibly, variation margin, which is calculated on a periodic basis, to track price changes. Hence, margin deposits are closely monitored to manage the risk of a possible default, like non-delivery or non-payment.
Also in the over-the-counter markets arrangements are made to manage counterparty risk. In case of bilateral deal-making, a party could agree with its counterparty to include a provision in their master agreement, which mandates the organisation of a mutual collateral solution.
A margin call, or a so-called ‘fed call’ or a ‘maintenance call’, is a message from a clearing organisation to deposit (additional) funds. It occurs when the value of the margin account has dropped below the level of the so-called ‘maintenance margin’. In that case, either additional margin has to be deposited or some positions have to be liquidated. When no action is taken, the clearing house will liquidate the position on behalf of the clearing member and on its account.
The goal of frequent margin calls (possibly daily) are to dynamically mitigate the risk of default that is faced by clearing organisations.
In a certain sense, margining margin is comparable to gaming in a casino. In a casino, a player first needs to buy chips (compare to depositing initial margin) before he is allowed to participate (compare to opening a position in the market). The chips (margin) guarantee that the player (market participant) is capable to face a certain loss.
As soon as the chips are lost new chips have to be bought (compare to depositing variation margin). After all, if an adverse scenario has come true (if the market has moved adversely), and a loss appears (on the contract), additional requirements have to be met. (In a casino this would mean new chips have to be bought, whereas in a cleared market this would mean that the margin requirement exceeds the actual deposit, so that a ‘margin call’ by the clearing organisation is addressed to the relevant counterparty, requiring an additional deposit).