In this LME Insight piece we take a look at margins, what they are, why they are important and how and when they are calculated.
The piece is aimed at those who have little to some knowledge of what margins are, as well as those who want to develop their understanding further, particularly on how margins are calculated, with examples throughout.
The essentials of margin
Margins are an important, even essential, element of financial markets. In its simplest sense, margin is like a down payment. It is a portion of the value of an asset being transacted.
In active derivatives markets most trading is done on margin and this adds greatly to the speed, efficiency and scope of trading.
Unlike securities trading (where traders normally have to pay the full value of the asset, up-front) derivatives traders can get full exposure to an asset by “trading on margin” – that is, only paying a percentage of the value of the underlying asset, upfront. In this sense margin is often seen as leverage.
Margin functions as collateral: security that allows a trader to borrow assets to be returned or paid for at the completion of the deal.
At its heart, margins are designed to protect traders, brokers and exchanges from counterparty risk. That is the risk that the other party in a trade defaults and is unable to honour or complete their side of the bargain or fulfil their contractual obligation.
The three different types of margin
The LME framework includes three different types margin; initial, variation and additional margin – together, the “total margin”. This basic calculation is common to most central counterparty clearing houses (CCPs).
LME margin framework:
How the LME calculate margins is relatively standard among major exchanges with a few important proprietary measures.
Initial and variation margin are applicable to all clearing members and positions. Beyond those, additional margin is assessed for specific situations regarding a member or a position.
Initial margin is just that – the initial calculation of the risks inherent to a position. Most of the time it is calculated using a standard algorithm applying known scenarios. The fundamental precaution is for the exchange to hold sufficient funds on behalf of a trader to offset any potential future losses that are incurred between the time of a potential default and the closing out of the position.
Additional margin is added to initial margin to account for any risks that are not captured in the standard algorithm. Variation margin (also sometimes called variable or maintenance margin) is a mark-to-market calculation.
Each of the three components is calculated on at least a daily basis. Some calculations are made through the course of the trading day, while others are done at the end of the day. Margin calls can be made at any time.
It should be noted that only LME clearing members can have accounts with LME Clear (the LME's clearing house), so most customers of the Exchange actually have to hold their contract via a clearing member. Clearing members require margins from their clients in the same way that clearing members pay margin to the clearing house.
Initial margin (SPAN)
As we have seen, initial margin refers to the funds put up as security for each contract at the opening of the position. The LME uses a specific algorithm, Standard Portfolio Analysis of Risk (SPAN), to calculate this initial margin. (SPAN is a registered trademark of Chicago Mercantile Exchange Inc and is used under licence)
There are three main components of the SPAN calculation: 1) scanning risk, 2) inter-prompt risk and 3) inter-contract risk.
Scanning risk is added to the inter-prompt risk and from that sum is subtracted the inter-contract risk. The margin parameters used within these calculations are reviewed on at least a monthly basis.
An important part of initial margin is scanning risk. It is the outright exposure of a trader holding a position in the commodity, whether that position is long or short. The basic implementation uses 16 scenarios to calculate loss values, or “risk arrays”. Beyond that, the LME has the ability to calculate loss values on an extended number of scenarios. This will be used in certain situations on specific portfolios, in consultation with the clearing member.
Scanning risk is a relatively standard calculation looking at historical price moves. It takes roughly two days to close out a position, so the LME calculates what could be the loss over the course of those two days. It’s not a worst-case calculation but one that covers 99% of adverse occurrences.
How is scanning risk calculated?
Scanning risk is calculated by multiplying the relevant “scanning range” (seen in the below example) by the number of tonnes in any given position.
Scanning range example:
|$ per tonne
|$ per lot
For example, a client wanting to hedge 20 lots (500 tonnes) of copper would need to pay initial margin (plus inter prompt risk and minus inter contract risk if relevant) of $317,000 ($634 x 500 tonnes) upfront in order to open this position.
To the scanning risk is then added the inter-prompt risk. That is the measure of risk between positions on different dates (or “prompts” in LME parlance). The methodology incorporates the relationship between spread level and forward volatility.
It reflects the analysis undertaken to identify the level of volatility in the market, which is largely dependent on whether the market is in contango or backwardation (ie whether the forward price is at a premium or discount to the nearby price). This is important for the LME, which has a very actively traded prompt-date structure.
In contrast, inter-contract risk can be a mitigating factor. Inter-contract credit reflects the delta-based correlation between the two (or more) contracts to which the credit is applied. This is when the underlying commodities demonstrate strong correlations with each other due to close economic links, but also distinct fundamental drivers that can create profitable trading opportunities (eg buying steel rebar and selling steel HRC).
This is why inter-contract risk is subtracted from the sum of scanning risk and inter-prompt risk. Essentially this provides a reduced margin on a portfolio of positions where the scanning risk is overstated when calculated on individual products.
High-level example of how SPAN works – linear products:
An active and robust exchange supports the trading of members and counterparties with large and innovative or unusual positions. In order to support such business, as well as to ensure the safety of all traders and the exchange itself, the LME calculates additional margin to account for risks outside the scope of SPAN.
There are four types of additional margin (AM): concentration, default fund, credit and discretionary.
Concentration AM is assessed when a clearing member’s, and its clients’ positions, are too large for the assumed liquidation period of two days. That is an automatic calculation, refreshed at the end of each day.
Default fund AM is applied where a clearing member’s stress-testing losses are in excess of a defined percentage of the default fund, an automatic overnight call will be generated to reduce stress testing losses to the defined level.
Credit AM is applicable when a clearing member’s internal credit score falls below a certain level, additional margin will be charged to cover stress-testing losses.
Discretionary AM will be charged when the LME is uncomfortable with the risk posed by a clearing member or their clients. Credit AM and discretionary AM are only charged after discussion with the clearing members involved.
There are two main types of variation margin: discounted contingent variation margin (DCVM) and realised variation margin (RVM).
DCVM is used for the LME’s physically settled suite of non-ferrous contracts (as well as average price futures). RVM is used for LME cash-settled futures.
Both DCVM and RVM use a straightforward calculation (see below for an example). Each day a futures contract is “marked to market”, ie its value is re-calculated based on the new LME Closing Price (or “Evening Evaluation”). If there is a fall in the value of the contract, the variation margin must be topped up so all members have no liabilities to LME Clear.
One of the key distinguishing features of physically settled LME contracts that use DCVM is that they are not “cash cleared” as RVM contracts are.
In other words, members and clients cannot remove the mark-to-market profit as cash before the contract’s final settlement, or prompt, date. However, they will be able to use any mark-to-market profit against margin requirements on other DCVM contracts and a range of collateral types to cover the losses. This is why LME physically settled futures are sometimes referred to a “forwards.”
Contracts using RVM, on the other hand, pay profits and require losses to be covered with cash on the day that those profits and losses are realised.
Variation margin example:
|Variation margin (VM)
Client A buys 20 lots copper @ $8400 for the prompt date of 30 September
LME Closing Price @ $8055 for the prompt date of 30 September
= (8400 - 8055) * 20 lots *25 tonnes (the contract size for copper)
= $172,500 (variation loss) which will need to be placed with LME Clear
If the position has further variation margin losses they will also need to be paid to LME Clear.
Client A sells20 lots copper @ $8450 for the prompt date of 30 September
= (8400 - 8450)* 20 lots * 25 tonnes
= $25,000 (profit)
The profit of $25,000 will remain as a profit on the account until paid out as US dollar cash on 30 September.
At the end of each business day LME Clear uses initial margin, additional margin, discounted contingency variation margin and realised variation margin to calculate the total margin requirement for each clearing member.
LME Clear has in place a robust risk management framework that provides the structure for clear risk policies, processes and internal control mechanisms to manage, assess and contain the risks posed to the clearing house and the market as a whole.
Contact and more information:
If you would like to find out more about margins and risk management at the LME please do not hesitate to get in touch.
For the latest margin parameters (including scanning ranges) visit our margin parameter files page.
We have also put together a risk document library for those looking for more in-depth information.