Central Counterparties: Mandatory Central Clearing and Initial Margin Requirements for OTC Derivatives

Chapter 9

Margin and Default Fund Methodologies

In the business world, the rear view mirror is always clearer than the windshield.

Warren Buffett (1930–)

This chapter describes margining in more detail. In particular, we focus on the methodologies for determining variation and initial margins, and default fund contributions. Initial margin methodologies for both CCP and bilateral markets are discussed. Cross-margining aspects are also considered.

9.1 VARIATION MARGIN

Variation margin is relatively simple conceptually, being just an adjustment for the change in mark-to-market value of the relevant positions at frequent periodic intervals. Valuation is relatively straightforward since a prerequisite for clearing is that the underlying trades are standardised and liquid. Variation margin will typically be cash in the trade currency. As a counterparty to all trades, CCPs are calculation agents, valuing all positions and collecting or paying respective margin amounts.

9.1.1 Valuation

Clearly, a CCP needs to have in place clear procedures for defining data sources and price quotes. However, OTC derivatives represent a greater challenge for variation margin calculations because valuations will potentially need to be generated by pricing models rather than being observed directly as market prices. One of the reasons for this is that longer-dated products do not remain liquid throughout their lifecycle and hence need to be marked-to-market based on models calibrated to similar liquid ...