Understanding London SPAN
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
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
1 5100 +10 5110 +10 1000CR 1000CR
2 +10 5140 +30 3000CR 4000CR
3 +10 5120 –20 2000CR 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 ) 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