Variation Margin

Variation margin is the payment that moves from one side of a derivative contract to the other to cover the change in the contract's value since it was last valued. If a position loses value, its holder pays; if it gains, its holder receives. It settles profits and losses as they arise instead of letting them build up until the contract ends.

Variation margin is one of the two main kinds of margin in derivatives markets. It is often confused with initial margin, the deposit posted when a trade is opened to cover losses that could occur if a counterparty defaulted. Initial margin guards against future losses; variation margin pays for losses already incurred. Both are collected by a central counterparty (CCP) for cleared trades and exchanged directly between firms for many OTC derivatives.

Picture two neighbours who bet on the price of fuel at the end of the year. Instead of waiting twelve months to see who owes whom, they agree to settle up every evening. If the price rose today, the neighbour who bet on a rise collects a small amount; if it fell tomorrow, money flows back the other way. At the end, nobody owes a large lump sum, because the debt was paid in small pieces along the way.

That evening settlement is variation margin. It keeps the score even, so a sudden default by one side can only cost the other a single day's movement, not a year's. The trade-off is that both neighbours must always have some cash on hand, because a bad week means paying out every day.

Each day the contract is revalued at a closing or settlement price, a process known as mark-to-market. The variation margin due is the change in value since the previous valuation:

• $\text{VM}_t$ is the variation margin for day $t$; a positive figure is received by the long side and paid by the short side.
• $Q$ is the number of contracts held.
• $M$ is the contract multiplier, the value of a one-point move per contract.
• $P_t$ and $P_{t-1}$ are today's and yesterday's settlement prices.

For example, a trader is long 10 crude oil futures contracts of 1,000 barrels each. The settlement price falls from 80.00 to 78.50 dollars a barrel. The trader owes $10 \times 1{,}000 \times (78.50 - 80.00) = -15{,}000$, so 15,000 dollars leaves the trader's account and is credited to holders of short positions. If the price recovers the next day, the flow reverses.

On futures exchanges, variation margin has been collected daily for more than a century, and large clearing houses can also call it during the day when prices move sharply. The clearing house stands between buyers and sellers, collects from members whose positions lost value and pays members whose positions gained. Because it nets everything to zero, the CCP itself carries no market exposure as long as every member pays on time.

For bilateral contracts such as an interest rate swap or a credit default swap, collateral used to depend on private agreements, and many trades were lightly collateralised before the 2008 financial crisis. After the crisis, the Basel Committee on Banking Supervision and IOSCO published a global framework for margin on non-centrally cleared derivatives. The largest firms began exchanging variation margin under it in September 2016, and all covered firms were required to do so from 1 March 2017. National rules apply it: in the United States through the CFTC and the banking agencies, and in the European Union through EMIR.

Cleared variation margin is normally paid in cash, typically the currency of the contract, so a position that is well hedged on paper can still drain liquidity when markets move. Bilateral agreements may also accept high-quality government bonds, sometimes with a haircut. Because payments must be made on a fixed schedule, firms keep cash buffers or credit lines to meet them.

The liquidity strain became visible in September 2022, when a sharp rise in UK gilt yields led to large collateral calls on the interest rate hedges held by pension funds using liability-driven investment strategies. Funds sold gilts to raise cash, pushing yields higher, and the Bank of England intervened with temporary gilt purchases from 28 September 2022. A missed payment of variation margin can trigger a margin call and, if it is still not met, the forced liquidation of the position.

• Procyclical cash demands. Margin is largest when markets are most volatile, which is when cash is hardest to raise.
• Valuation disputes. For thinly traded OTC contracts there may be no clear market price, and the two sides can disagree about the amount due.
• Mismatched timing. A firm that hedges a physical asset with derivatives may pay variation margin today while the offsetting gain on the asset is only realised months later, a gap that hedge accounting addresses in the financial statements but not in cash.

• Bank for International Settlements: Margin requirements for non-centrally cleared derivatives
• Commodity Futures Trading Commission