Cross margining

From CEOpedia | Management online

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 [1].

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[2].

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[3].

Examples of Cross margining

  • Cross margining is commonly used by brokerage firms to reduce their own risk in the event of a client's margin call. For example, a broker may use the excess margin in one client's account to cover the margin call in another client's account. This provides the broker with a more secure form of protection against potential losses due to default on the part of the client.
  • Cross margining is also commonly used by futures traders to spread their risk across multiple markets. For example, a trader may buy a futures contract on the S&P 500 index and then hedge the position by buying a futures contract on the NASDAQ index. In this way, the trader can spread their risk across two different markets, reducing the overall risk of their position.
  • Additionally, cross margining is used by options traders to balance out their risk exposure. For example, a trader may buy a call option on a stock and then buy a corresponding put option on the same stock. By doing this, the trader is able to reduce their overall risk by balancing out their potential profits and losses.

Advantages of Cross margining

Cross margining is a process of margining related to securities, options and futures contracts. The main advantage of cross margining is that it reduces the risk of default for both the financial institution and the client. This is because it allows the financial institution to use the excess margin from one account to cover the margin requirements of another. Other advantages of cross margining include:

  • It allows financial institutions to manage their exposure to risk more efficiently. By combining multiple accounts with different margin requirements, they are able to more easily monitor and manage the overall risk of their portfolio.
  • It also allows for better asset diversification. By combining multiple accounts with different margin requirements, a financial institution can spread out its risk across a larger number of investments.
  • Finally, cross margining can help to reduce the cost of margin calls. Since the financial institution is able to use the excess margin from one account to cover the margin requirements of another, they are able to reduce the amount of money they have to pay out in margin calls.

Limitations of Cross margining

Cross margining has some limitations that must be taken into consideration when applying it to your trading strategies. These limitations include:

  • Risk - Cross margining carries a risk of one party not being able to cover its margin requirements, thus leading to a potential loss for the other party.
  • Regulation - Cross margining can be subject to different regulations in different countries and states, thus making it difficult to apply it across different jurisdictions.
  • Complexity - Cross margining is a complex process that requires knowledge of different markets and the legal and financial rules that apply to them.
  • Volatility - Cross margining can lead to exposure to higher volatility than expected, as the margin requirements are subject to change in the markets.
  • Liquidity - Cross margining can lead to lack of liquidity in certain markets, as the collateral and margin requirements are subject to change.

Other approaches related to Cross margining

Cross margining can also be used in other situations as well. Here are some of the approaches related to this practice:

  • Portfolio margining: This approach is used to calculate the total margin requirements for a portfolio, which contains multiple positions in different assets such as stocks, options or futures contracts.
  • Margin offsetting: This approach is used to reduce the margin requirement from one position in order to cover the margin requirement of another position. This is usually done with positions in different asset classes, such as stocks and futures.
  • Inter-exchange margining: This approach is used in situations where margin requirements vary between different exchanges. It is used to offset the difference between the margin requirements of different exchanges.

In summary, cross margining is a practice that is used to reduce the risk associated with clients who are unable to pay a margin call. It involves approaches such as portfolio margining, margin offsetting and inter-exchange margining.

Footnotes

  1. ↑ Gromb, D., & Vayanos, D. (2002). Equilibrium and welfare in markets with financially constrained arbitrageurs.
  2. ↑ Filler, R. H., Markha, J. W. (2014) Regulation of Derivative Financial Instruments(Swaps, Options, and Futures)
  3. ↑ Maguire, F. (2005) Cross-asset trading and risk management


Cross margining — recommended articles
Variation Margin — Noncovered security — Concentration risk — Embedded derivative — Margin level — Credit instrument — Umbrella fund — Net line — Trading Book

References

Author: Pola Ligaj

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