Clearing, Settlement and Custody

Appendix 2

Understanding London SPAN

T

he primary role of LCH is to act as central counterparty to trades

executed by its members:

䊏 In futures and options contracts on the London International

Financial Futures and Options Exchange (LIFFE), the London

Metal Exchange (LME) and the International Petroleum Exchange

(IPE)

䊏 In certain classes of over-the-counter (OTC) products, specifically

interbank interest rate swaps, repos and cash bonds

䊏 For equities traded on the London Stock Exchange’s SETS system

䊏 OTC energy swaps transacted on the Intercontinental Exchange

announced 29 August 2001

䊏 In 2000 LCH cleared approximately 224 million contracts traded

on the London exchanges.

When LCH has registered a trade, it becomes the buyer to every LCH

member who sells and the seller to every LCH member who buys,

ensuring the financial performance of trades. To protect itself against

the risks assumed as central counterparty, LCH establishes the margin

requirements as described below.

What is margining?

As central counterparty to its members’ trades, LCH is at risk from

the default of a member. To limit and cover such potential loss, LCH

collects margin on all open positions and recalculates members’

margin liabilities on a daily basis. There are two major types:

䊏 Initial margin

䊏 Variation margin

Initial margin is the deposit required on all net positions and is

returned by LCH to members when positions are closed. Members

may impose more stringent initial margin requirements on their own

customers, in accordance with the rules of the relevant exchanges.

Variation margin is members’ profits or losses which are calculated

daily from the market-to-market close value of their open position.

These amounts, depending on individual contract terms, are either

realized – that is, credited to or debited from member accounts – or

treated as unrealized profits or losses.

Realized variation margin

Many contracts are subject to daily variation margin payments and

receipts. For example, a member buys 10 December FT-SE 100 index

futures at 5100 points and later sells at 5110 points. The contract size is

£10 per index point. Given the daily price moves shown below, the

variation margin payments to (CR) and receipts from (DR) the

member during the life of the open position would be as follows.

Clearing, Settlement and Custody182

Day Trade

price

Net

position

Closing

price

Price

movement

Variation

margin (£)

Cumulative

variation

1 5100 +10 5110 +10 1000CR 1000CR

2 +10 5140 +30 3000CR 4000CR

3 [phone]CR 2000CR

4 5100 0 –10 1000DR 1000CR

Total variation margin over duration of position 1000CR

The difference between the future’s price (5100 points) and the price

at which the trade was closed (5110 points) represents a net profit of

10 points, so a total variation margin receipt of £1000 (net profit [10

points] *no of lots [10]) will have been credited to the member over

the duration of the position.

Discount variation margin

For the London Metal Exchange’s (LME) contracts profit or loss is

not immediately realized but becomes due on the prompt date of the

contract. Its value is therefore not its absolute amount, but the

amount discounted by the interest return which would be made if the

money were immediately available.

Thus, for a contract (e.g. CAD) forwards variation margin for a given

trade for a given prompt date is calculated as:

VM = (closing price – trades price) × net position

The values at prompt date level are discounted to present value by

multiplying by a discount factor for that prompt date. The discounted

variation margins for each of the prompt dates in the portfolio are

summed to give a single discounted forwards variation margin figure

for that contract which could be positive or negative.

Net liquidating value

Net liquidating value is calculated on all premium paid up front

options. For example, a member sells a December Boots option

contract for a premium of £0.10 a share (1 contract = 1000 shares).

Given the daily price movements shown below, unrealized variation

margin during the life of the position is as follows.

Credit net liquidating values can be used to offset other liabilities.

Debit net liquidating values must be paid.

Understanding London SPAN 183