What Is a Variation Margin Deposit?
Learn how daily settlements in financial contracts manage risk and maintain stability in dynamic markets.
Modern financial markets are characterized by intricate transactions and interconnectedness, making effective risk management a fundamental practice. Derivatives, financial instruments whose value is derived from an underlying asset, play a significant role. They allow investors and businesses to manage various exposures, such as market volatility, currency fluctuations, and interest rate changes. Managing risks associated with these instruments is essential for financial stability.
Understanding Variation Margin
Variation margin (VM) is a payment exchanged between parties in a derivatives contract to cover changes in the market value of that contract. It is a daily payment that reflects the realized profit or loss on an open position. This mechanism aims to reduce counterparty credit risk by ensuring that gains and losses are settled promptly, typically at the end of each trading day. The concept is often referred to as a “deposit” because the party whose position has incurred a loss must deposit funds to cover that loss, bringing their account balance back to the required level.
The primary purpose of variation margin is to prevent the accumulation of large, unsettled gains or losses that could lead to defaults. Unlike initial margin, which is a deposit made at the outset to cover potential future exposure, variation margin addresses current, realized gains or losses. Initial margin serves as a performance bond, while variation margin ensures daily fluctuations in contract value are settled immediately.
Daily Operations of Variation Margin
The application of variation margin relies on “mark-to-market,” which involves revaluing derivatives contracts daily based on prevailing market prices. At the close of each trading day, profit or loss for each party is calculated by comparing the contract’s current market value to its previous day’s settlement value. If a contract’s value moves unfavorably for one party, they incur a loss, and the other party realizes a gain.
When a party’s position loses value and their account balance falls below a threshold, they receive a “margin call.” This is a demand from a broker or clearinghouse for additional funds or eligible assets to bring the account balance back to the required level. These payments are due within a short timeframe, often by the end of the trading day or the beginning of the next. Variation margin payments involve the actual transfer of cash or highly liquid assets, not just accounting entries.
Where Variation Margin Applies
Variation margin applies across segments of the derivatives market, particularly in centrally cleared and over-the-counter (OTC) derivatives. In centrally cleared derivatives, such as futures and standardized swaps, central clearing counterparties (CCPs) mandate the exchange of variation margin. The CCP acts as an intermediary, guaranteeing the performance of both sides of the trade.
CCPs require variation margin from both parties to manage the daily market risk and ensure the stability of the clearing system. This centralized approach significantly reduces counterparty risk by mutualizing potential losses. For over-the-counter (OTC) derivatives, which are customized contracts traded directly between two parties, the exchange of variation margin became widely mandated following the 2008 financial crisis. Regulations like the Dodd-Frank Act in the United States and the European Market Infrastructure Regulation (EMIR) in Europe introduced requirements for daily variation margin exchange for many non-cleared derivatives between certain financial entities. These regulations aimed to enhance financial stability by reducing systemic risk in the bilateral OTC market, requiring parties to collateralize their marked-to-market exposure.