Cross margining in simple terms it means a procedure concerned with margining related to securities, options as well as futures contracts together when different clearing organizations. In other words, it is a brokerage practice consisting in using the excess margin on the margin account of a client to cover another margin account, which is below margin requirements. An account, which is below margin requirement must be subjected to a margin call, however, some financial institutions use cross margining in order to reduce the risk when a client is not unable to pay a margin call, which in turn may cause serious problems for the involved parties. Another term for cross margining is a spread margin. Another way of defining cross-margining is referring to it as a practice related to the reduction of the total margin payment made by the market participant, which in turn allows other participants who trade in related products and probably on more than one market (for instance, derivative and cash markets) to acknowledge reduced risks concerned with offsetting the open positions (for instance, in the event when some drop in a position's value in one market is offset by a gain in a corresponding position's value in a different market).
Cross margarine objectives
The method of cross margining, which is also known as spread margining, uses full amount of funds in the available balance to circumvent liquidations. This method is practical for users who want to secure existing positions, but also for arbitragers who do not want to risk on one side of the trade in case of winding-up. Cross margining was introduced at the end of 1980s, when financial instruments encountered intensified market volatility, with the aim of increasing company’s liquidity and financing flexibility by means of reduced requirements concerning initial margin and lower net settlements .
How Cross margining works?
Prior to establishing cross margining, market participant had liquidity issues if they had a margin call from one clearinghouse having problems with offsetting a position held at another clearinghouse. The cross margining system connects margin accounts for member companies so that the margin can be shifted from the account that has excess margin to an account that requires margin. By the end of a trading day, clearinghouses send settlement activities reports to organizations such as:
- Intercontinental Exchange (ICE)
- Options Clearing Corporation,
which in turn:
- do the calculations for clearing level margins,
- issue settlement reports to clearing members.
Prime brokerages are also able to render cross margining services by way of cooperating with the clearinghouses on behalf of their clients.
Motivation to used cross margining
The fundamental motivation to take advantage of cross margining is nothing else but:
- risk management of a sophisticated
- complex financial instruments portfolio.
- Saving of costs from more efficient placement of the margin is much less important.
Advantages of cross margining are well known to institutional investors, however they have to double check that proper correlations of assets in their portfolio, despite what trading strategy is employed, are modelled and monitored in such a way as not to get exposed in extreme trading environment. Furthermore, despite the fact that margin may be shifted friction-free among accounts to meet minimum requirements, it is also vital that the traders do not maintain margin balances too low, since it could limit the flexibility in case of market volatility.
- Gromb, D., & Vayanos, D. (2002). Equilibrium and welfare in markets with financially constrained arbitrageurs.
- Filler, R. H., Markha, J. W. (2014) Regulation of Derivative Financial Instruments(Swaps, Options, and Futures)
- Maguire, F. (2005) Cross-asset trading and risk management
- Filler, R. H., Markha, J. W. (2014) - Regulation of Derivative Financial Instruments(Swaps, Options, and Futures) West Academic Publishing, New York
- Gromb, D., & Vayanos, D. (2002). Equilibrium and welfare in markets with financially constrained arbitrageurs. "Journal of financial" Economics, 66(2-3), 361-407.
- Maguire, F. (2005) - Cross-asset trading and risk management), "Derivatives Use, Trading & Regulation Volume Eleven" NR. 3
Author: Pola Ligaj