Cross-margining is the practice of calculating margin requirements across positions in different but related products, accounts or clearing houses as if they formed one portfolio. If a firm is long a futures contract and short a closely related option or cash bond, the two positions tend to offset each other's gains and losses. Cross-margining recognises that offset and lowers the combined initial margin, freeing collateral for other uses. It is used by central counterparties, their clearing members and, in some markets, the members' clients.
There are two main forms. Within a single CCP, related products may be margined together, often called portfolio margining. Between separate CCPs, a cross-margining agreement links the clearing houses so that a member's positions at each are viewed together. Cross-margining differs from netting: positions are not cancelled against each other, they remain open, but the collateral held against them reflects their combined risk.
Cross-margining in plain terms
Someone who owns an umbrella shop and an ice-cream stand is less exposed to the weather than someone who owns only one. Rain hurts ice-cream sales but helps umbrella sales. A lender that looked at the two businesses separately would ask for security against each one's worst day. A lender that looked at them together would see that both rarely have a bad day at once, and ask for less.
Cross-margining is the second lender's view, applied to trading positions. The clearing house looks at related bets together and asks for collateral that matches their combined risk, rather than adding up the worst case of each.
How cross-margining works
A CCP's margin model, often based on historical simulation or value at risk methods, estimates how much a portfolio could lose over the period needed to close it out after a default, the margin period of risk. Under cross-margining, the model is run on the combined portfolio. Where products are strongly correlated and the correlation is expected to hold in stress, the combined requirement is lower than the sum of separate requirements.
In a two-CCP arrangement, the clearing houses agree how the reduced margin is shared, how collateral is held, and how the combined portfolio would be closed out if the member defaulted. Collateral may be held in a joint account or by each CCP under cross-guarantees. Each CCP still collects variation margin on its own positions every day.
Examples
US markets have long used cross-margining between clearing houses for related products, such as arrangements linking equity options cleared at the Options Clearing Corporation with equity index futures, and arrangements between the Fixed Income Clearing Corporation and CME linking US Treasury securities with Treasury futures. The latter received renewed attention as authorities pushed for wider central clearing of Treasury trades. In OTC derivatives, some CCPs allow portfolio margining of interest rate swaps with listed interest rate futures cleared in the same group.
Benefits
- Lower collateral costs. Members post margin that reflects their real net risk, which can reduce the total required substantially for hedged portfolios.
- Better liquidity. Collateral freed up can be used elsewhere, easing liquidity risk in stress.
- Incentive to hedge. Recognising offsets makes it cheaper for firms to hedge, which can reduce overall market risk.
Risks and safeguards
Cross-margining is only safe if the assumed offset survives a crisis. Correlations between products can break down sharply in stressed markets, leaving a CCP under-margined at the worst moment. Two-CCP arrangements add legal and operational complexity: if a member defaults, the clearing houses must coordinate their default management, close out positions on different platforms, and share any loss under the agreement, possibly before drawing on their own clearing fund.
The Principles for Financial Market Infrastructures allow CCPs to offset or reduce margin across products only where the price risk of one product is significantly and reliably correlated with that of the other, and where the CCP can apply appropriate safeguards. When two or more CCPs are involved, they should have appropriate safeguards and harmonised overall risk management. Regulators also require clear legal agreements, robust stress testing of the combined portfolio, and conservative limits on how much margin reduction is allowed.