The Hindu Business Line : Role of margin money

In an earlier article in these columns, we looked at Forward and Futures contracts and saw how futures transactions are carried out through recognised exchanges and regulated. Under the Forward Contracts (Regulation) Act, 1952, forward trading in commodities notified under section 15 of the Act can be conducted only on exchanges granted recognition by the Central Government’s Department of Consumer Affairs. A commodity futures exchange is usually a mutual body of traders and other stakeholders (producers, processors, consumers) in the commodity business or a demutualised body. Either case, it provides a platform for buyers and sellers to transact business.

Trading is done either by ‘open outcry’ system or online using computers. In the open outcry or pit trading system, traders/brokers meet in a trading ring. The buy/sell transaction is recorded by the exchange. In the online trading system, there is no physical contact between parties. The exchange keeps a record of transactions and oversees the performance of the contract.

An exchange designs a futures contract for trading on its platform. The terms of the contract are standardised. What the parties negotiate is only the price, and nothing else as all other terms (quality, quantity, period and place of delivery) are pre-determined. The exchange also provides facilities for clearing and settlement. An arbitration facility too is put in place.

It is absolutely necessary for the exchange to provide a financially secure environment for participants. This is achieved by putting in place appropriate risk management systems.

Indeed, the exchange guarantees the performance of the contract registered with it. It may also be done by a clearing house.

Although buyers and sellers enter into buy/sell transactions, technically, the seller sells to the exchange and the buyer buys from the exchange. In other words, the exchange interposes itself between the buyer and seller. The exchange thus becomes a seller to each buyer and a buyer to each seller. Thus, the exchange becomes the counter-party to every contract. Because buyers and sellers trade via the exchange, it is the responsibility of the exchange to ensure performance of the contract.

Margin money

To safeguard the integrity of the market and its own interest, the exchange imposes what is called margin money. Different types of margins imposed on futures contracts include Ordinary/Initial margin; Mark-to-market margin; Special margin; Volatility margin; and Delivery margin. The purpose of the margin is to minimise the risk of default by either counter-party.

Initial margin is the amount to be deposited by the market participants in their margin account with the clearing house before they can place buy or sell order of a futures contract. This amount must be maintained throughout the time their position is open and is refundable at delivery, exercise, expiry or closing out.

Mark-to-market margins (valan in local parlance) help protect the interest of the exchange itself. The exchange clears all the transactions at the closing price of the day; profits and losses are either paid in or paid out.

These margins, payable based on the closing price at the end of each trading day, will be paid by the buyer if the price declines and by the seller if the price rises. This margin is worked out on the difference between the closing/clearing rate and the rate of the contract (if it is entered into on that day) or the previous day’s clearing rate.

The exchange collects these margins from the buyers if the price declines and pays to the sellers, and vice-versa. This minimises the chance of default as both buyer and seller are exposed to only one day of price movement.

Collecting mark-to-market margin on a daily basis reduces the possibility of accumulation of loss, particularly when the futures price moves only in one direction. The risk of default is reduced. Also, market participants are required to pay less upfront margin, which is normally collected to cover the maximum, say 99.9 per cent of the potential risk during the period of mark-to-market, for a given limit on open position.

Alternatively, for the given upfront margin, the limit on open position would have to be reduced, something that will have the effect of restraining trade and liquidity.

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