Collateral Management (The Complete Guide 2019)

Collateral Management

Collateral Management: The Complete Guide 2019

The collateral management function is an important function in the derivatives business. Collateralization is an essential tool used in counterparty credit risk management. It is used in a number of business areas including derivatives transactions, repurchase agreements, and securities lending.


After the Dodd-Frank Act and similar laws were passed in major derivative markets around the world, new and more stringent collateral management standards have been introduced. This Guide explains complete Collateral Management.


According to new regulations, all central counterparty (CCP) organizations (clearinghouses) are required to adapt to robust collateral management models to maintain economically strong clearing organizations.


The laws also enforce higher collateral requirement standards and other rules for all non-cleared derivative transactions between market participants to protect and promote the safety of all market participants.


This blog starts with an introduction to the overall collateral management process in the derivatives market. It goes on to explain both the margin management model that is used for listed and cleared products and the counter-party collateral management model used for bilateral transactions, together with the collateral custody model implicit in both those models.


Finally, it briefly explains the different aspects of enterprise collateral management—an emerging trend in financial and nonfinancial firms.


This blog explains the essential principles of collateral management. Following blogs on the life cycles of various product groups provide further details in relation to the different product groups (futures, listed options, OTC cleared, and OTC bilateral).


The objectives of this blog are to

  • understand the use of collateral as a risk management tool in derivative transactions
  • discuss new collateral management standards introduced through the Dodd-Frank Act and other similar reforms
  • explain the margin model used in listed and cleared derivatives transactions
  • explain the counterparty collateral management model used in OTC bilateral derivative transactions
  • describe the collateral custody model in listed, cleared, and bilateral transactions
  • identify the importance and various aspects of enterprise collateral management


Derivatives Collateral Management

Derivatives Collateral Management

Counterparty credit risk is one of the major risk factors in derivatives transactions. Collateralization is a significant credit risk mitigation tool as it provides protection in the event of a default on the transaction.


The regulatory reforms including the Dodd-Frank Act and similar reforms around the world introduced stringent collateral management rules in OTC markets and changed the overall collateral management practices.


After reforms, financial institutions and corporations are required to manage their collateral assets better than ever. Especially in the derivatives business, the collateral management function plays a critical role inasmuch as derivative contracts may carry large credit risk.


The following sections briefly explain some general aspects of collateral management.




Collateral describes an asset used to secure some kind of transaction between two parties. In general, the collateral could be an asset—such as cash, securities, or guarantees—that is acceptable by the parties involved in the transaction.


In the event of one of the parties’ failure to honor obligations, the other party has the right to liquidate the collateral to recover those obligations.


In a financial derivatives transaction, cash and government and high-grade corporate securities are commonly used as collateral assets. For simplicity, this blog treats only cash and securities as collateral.


The party that pays the collateral is referred to as the collateral giver, collateral provider, or pledging party. The party that receives the collateral is referred to as the collateral holder or collateral taker.


As a result of the current value of the contract, the collateral provider or transferor is obligated by contractual terms to provide sufficient collateral. In such a case, the collateral taker, or transferee, collects the collateral from a counterparty to secure the contract that exists between them.


Credit Exposure

Credit Exposure

As discussed in blog, counterparty exposure is generally defined as the amount lost in the event of a counterparty defaulting or failing to fulfill obligations. The exposure amount may include components such as the contract replacement cost and potential future exposure.


The actual definition of exposure may include some other parameters and may vary by product type, market, and local law. The assets held as collateral may reduce or cover the total counterparty exposure.


As discussed earlier, derivative contracts can be divided into two major categories based on the exposure: centrally cleared and bilateral. The major difference between these two categories is the counterparty exposure to the contract holder.


In a centrally cleared contract (listed and OTC cleared), the counterparty exposure is concentrated at CCP because all contract holders face a CCP. CCPs employ best collateral management policies that make them strong and sustain severe defaults.


The counterparty risk that clients face from a CCP is considered negligible because of the firm counterpart risk management policies adopted by a CCP.


In a bilateral contract, each party is exposed to the credit risk from the other party of the contract. To mitigate this risk, parties directly collect the collateral from each other.

Actual calculations of exposure and other details are beyond the scope of this blog.


Collateral Management Models

Collateral Management Models

In derivatives markets, there are two major collateral management models in use. They are the margin account model, or simply margin model, and the counterparty collateral management, or simply collateral management model. They are briefly explained below and are thoroughly discussed in later sections.


Margin Management

Margin Management

The margin model is used by CCPs (or clearinghouses) for listed and cleared transactions. This is a one-way model in which collateral is posted only by clients. End-clients post their collateral to clearing members and, in turn, to the CCP.


The margin model in a listed market is old but efficient. By contrast, the margin model for cleared contracts is relatively new and quite similar to a listed market model. The underlying contract valuation models, collateral custody, and other rules are prescribed by the respective regulatory agencies.


Collateral Management

positive contract value

Although the term collateral management covers a broader subject, it is commonly used in an OTC bilateral market. In this model, the counterparty with a positive contract value (the party with credit exposure) holds the collateral from the other counterparty. The contract is evaluated using the method specified in the agreement.


This is typically a two-way collateral exchange between counterparties. The collateral management in bilateral markets has been reformed as part of the Dodd-Frank Act, as well as related reforms in global OTC markets. The collateral management in bilateral markets is a two-way direct collateral exchange between counterparties.


Moreover, new regulations prescribe various rules to protect the collateral posted by counterparties in bilateral transactions. This model and other regulatory details are discussed in later sections of this blog.


Note The term margin has a different meaning in securities trading than in derivatives trading. In the securities market, the margin is a borrowed fund (loan) to purchase stock or bond.


In the margin account, an account holder can purchase new securities with the loan proceeds using the securities held in that account as collateral. Conversely, in a derivatives market, the margin is analogous to a performance bond or a security deposit to enter into a contract.


Margin Call

collateral requirement

A margin call is a demand notice from one party to another requesting fund to fulfill the collateral requirement, as per the legal agreement between parties. According to collateral agreement terms, contracts are evaluated and margin calls are issued at regular intervals, such as daily or weekly.


However, in the case of large movements in the contract value due to a volatile market or any other event, a margin call may occur intraday or more frequently than normal.


This is referred to as an intraday margin call. The date and time at which a contract is evaluated and the collateral calculation performed is known as a valuation date and valuation time.


In derivatives transactions, typically, one margin call per contract is issued with the netted collateral amounts of all transactions. It may even include fees, interest, and other payments.


Regulatory Reforms

Regulatory Reforms

Most global listed markets continue to use an existing margin model that is proven to be safe. However, Dodd-Frank and similar regulations have reformed the collateral management practice in OTC cleared and bilateral transactions.


Cleared transactions use a standard margin model framework with mechanics that comply with new regulatory requirements.


For bilateral transactions, regulatory rules prescribe collateral eligibility, custody, and the timing of posting and other rules. These reforms mostly focus on swap dealers and major swap participants as they play a major role in the OTC bilateral market.


Collateral Transfer

Collateral Transfer

In general, collateral assets (securities) are transferred in either of two forms: ownership transfer or pledge. When the collateral is transferred in full ownership from Party A to Party B, at the time of the return, Party B is required to return the same quantity of the same security.


In the other form of transfers, pledge, the delivered securities remain the property of the original owner although they are held with the other party. The owner may replace them with the same value asset, as needed. The collateral holding party has the right to dispose of this collateral, but only in case, the owner fails to fulfill contractual obligations.


In the case of cash, it is simply transferred from one party to other.

The reinvestment (re-use) rules of the collateral by the collateral receiver— Party B in this case—are dictated by applicable regulatory rules.


Margin Model

Margin Model

As explained earlier, after clearing each trade will create two contracts, each between the CCP and the original party, simultaneously. These contracts are opposite in nature and are created at the same time.


Hence, the market risk from these contracts is virtually eliminated because the change in the market value of one contract will be offset by an opposite contract. However, the counterparty risk at CCP remains.


All CCPs (clearinghouses) use the margin account model, or simply the margin model, for listed and cleared contracts. In this model, the CCP manages counterparty risk mainly by collecting deposit (initial margin) for open contracts and daily settlements of the change in the contract value, resulting from market movement (variation margin).


Thus, at any given point, the exposure from market movements (market risk) for the CCP is limited to the contract value change from the last settlement (previous business day). This exposure is expected to be covered by the initial collateral collected from a contract holder in the case of a default.


This is a one-way model where collateral (generally referred to as a margin) is posted only by clients (end-clients). Clients post their collateral to a clearing member and, in turn, the clearing member posts it to the CCP.


In cases in which a clearing member owns positions (house accounts), the clearing member becomes the client and is required to post the collateral to the CCP like any other client.


The margin model is defined by the CCPs. The clearinghouse defines the margin requirements, acceptable collateral, and all other rules for each type of contract that it clears.


Minor details of the margin management process vary by each clearinghouse. However, the overall model remains uniform across all clearinghouses. The following sections describe the overall process and essential concepts.


Margining Process

Margining Process

The overall margin process consists of the following steps, detailed in subsequent sections. At the end of each business day, the following steps are performed at a clearinghouse for each clearing member account and similarly at the clearing member firm for each end-client account:


  • Update positions. At the end of each business day, each account is updated to reflect new and closed positions and collateral postings.
  • Valuation (positions and collateral). All positions and current collateral are evaluated to determine their current market value.
  • Calculate initial margin. Required collateral is calculated using a predetermined model.
  • Calculate the variation margin. The change in market value from the last settlement is calculated for each contract. The result is a profit or loss (return) on a contract.


  • Update margin account. A margin account is updated to reflect initial margin, variation margin, and other fees to determine the net account value.


  • Margin call. If the net account value is lower than the required margin, the margin call is issued for an additionally required amount.
  • Publish market data. The clearinghouse publishes market data used for valuation and is published to a clearing member and the public.
  • Reporting. The clearinghouse and clearing members send margin reports to their clients.


Margin Calls

Margin Calls

As explained above, the clearinghouse computes the margin requirements at the end of each business day and sends margin calls to its members. Similarly, each clearing member computes the margin requirements for all its clients and sends margin calls.


The margin amounts are settled as per the settlement terms. In most cases, they are settled T+0 (same day) or T+1 (next day).


Alternatively, if there is an excess amount in the clearing member’s account or in the client accounts, daily reports will reflect those amounts. The account owner is free to withdraw the excess assets.


Intraday Margin Calls

In addition to the daily margin call issued at the end of the day, the clearinghouse (or clearing member) may also send an intraday margin call if any account value drops below the threshold due to drastic market changes or other reasons.


Margin Account

Margin Account

A margin account is the centerpiece of this model. The clearinghouse maintains the margin account that holds the collateral and daily settlements for positions of a clearing member.


For each clearing member, the clearinghouse separates end-client positions and the clearing member’s proprietary position into different accounts. This is done to avoid a client collateral leverage by the clearing member.


Similarly, the clearing member (CM) maintains a margin account for each client to manage the collateral and settlements for all positions of that client. Furthermore, non-clearing member firms access a clearinghouse through a clearing member to manage the margin of their clients.


A clearing member can combine all positions of the client into a single account or maintain multiple accounts segregating contracts based on some criteria, such as one account for all those that are listed and another account for cleared contracts. However, this is done in accordance with the applicable regulatory rules.


In general, daily transaction activity that impacts account value includes new positions added to the account and the closing of existing positions, the transaction fee, changes in an open position value, change in collateral value, and new collateral that is posted.


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Contract and Collateral Valuation

Collateral Valuation

In a margin model, all open positions are valued using official closing prices determined by a clearinghouse every day. Also, collateral securities are valued using closing prices.


 The clearinghouse publishes all official market data such as closing prices, interest rate curves, and any other parameter used to evaluate positions and collateral. This data is used by clearing members and end-clients to value positions and collateral on their end.


Margin Types

There are various components involved in margin flows. Two major components are the initial deposit, which is known as the initial margin, and returns (profit or loss), which are known as variation margin, from the market movements. The following sections explain these margin types and margin account thresholds.


Initial Margin

Initial Margin

Listed and cleared contracts require an initial deposit, known as an initial margin (IM), from contract participants during the inception of a new contract. This deposit is returned upon maturity or the termination of the contract.


The actual deposit amount is specified by a contractor is determined by the clearinghouse rules. Sometimes it is also known as a good faith deposit since it is returnable, or a performance bond.


As discussed earlier, the primary objective of IM is to cover a change in contract value from the last settlement (the previous business day). So, it is typically a small portion of the contract value. In practice, IM is computed at an aggregate level such as a portfolio of all open positions.


Since the IM is a deposit, the depositor legally owns it. If this deposit is cash, it usually earns a nominal interest.


But the clearing member has the right to take possession at any time if the client positions require collateral. Consequently, the clearinghouse has the right to take possession of the clearing member’s deposit.


Note that the initial margin set by a clearing member might be more or the same amount as a clearinghouse. This is left up to the clearing member’s discretion. However, the clearing member must maintain minimum levels as advised by the clearinghouse.


Variation Margin

Variation Margin

At the end of each business day, an open position is marked-to-market and the resulting change in value (profit or loss) is either credited to or debited from the margin account. This change in the value of the contract is known as the variation margin (VM), or variously variation, settlement variation, or mark-to-market amount.


Maintenance Margin

The maintenance margin is the minimum amount (or threshold) that needs to be maintained in a margin account by the account owner. When the account balance falls below the maintenance margin, the account holder is required to post the collateral to restore the account to the levels of required (initial) margin amount.


The amount required to be deposited is also known as the daily variation margin (DVM) or simply as the account variation margin (in the context of an account).


For instance, assume that the initial margin is $1,000 and the maintenance margin is $600 of the account. If the net account value falls to $500, then the account holder is required to deposit $500 to bring the account balance back up to $1,000.


The minimum amount (maintenance margin) is a certain percentage of the current market value of positions. When a client fails to maintain this level, the holding entity (clearinghouse or clearing member) may immediately liquidate some or all of the client’s positions.


Additional Margin

In addition to the regularly required margin (initial margin and variation margin), from time to time a clearinghouse may request additional margin from certain members. This is not common except in certain situations such as stress losses that are larger than the expected thresholds.


Margin Calculation

Margin Calculation

Each clearinghouse may have different margin calculation methods that are explained by the rule blog of a clearinghouse. The clearinghouse calculates the value of a position and margin for all its direct members (clearing members).


Clearing members use the same market prices to compute client position values and may use a similar margining model used by the clearinghouse. However, overall margining requirements by a clearing member may be higher in certain cases for extra protection.


In the case of listed futures and options, many clearinghouses use the Standard Portfolio Analysis (SPAN) method, developed by the Chicago Mercantile Exchange (CME). Essentially, it is a portfolio margining method that computes the margin requirement using the portfolio level risk instead by each contract.

Span To learn more about SPAN, visit CME SPAN: Standard Portfolio Analysis of Risk.


Reconciliation and Reporting


Daily activity and margin reports are distributed by the clearinghouse to clearing members and the clearing member to end-clients. At the end of each business day, end-clients reconcile their transactions with clearing member reports. Similarly, clearing members reconcile their transactions with the clearinghouse.


Default Handling

The details of the default handling process vary by CCP and applicable regulatory and local laws. The end-client, the clearing member, or both might default.


In such situations, the CCP uses funds from liquidating the defaulting client’s open positions, collateral being held, funds from the CCP guarantee fund, a credit insurer if any, and equity capital of the CCP until the losses are covered.


These resources together will make it easy to cover any potential losses from even reasonably larger defaults. The details of default handling are generally explained in the rule blog of each clearinghouse.


Agreements and Documentation


In a listed market, the clearinghouse essentially drives all legal documentation. A clearinghouse provides the license to its members to clear end-client contracts. In addition, the clearinghouse governs the overall margining process of its members. Each end-client enters into an agreement with the clearing member.


Furthermore, a clearinghouse may hold details of each end-client for monitoring and other purposes.


In a cleared market, as regulatory requirements vary, CCPs may or may not use the agreement used for the listed market. However, the overall legal documentation framework remains the same with rules satisfying regulatory requirements.


Cleared Contracts and Margin Model

Cleared Contracts

Most clearinghouses that clear OTC contracts also clear listed transactions. The margin model used for cleared transactions is similar to the model used for listed transactions. Similar to listed contracts, cleared contracts require an initial margin with the variation margin settled daily.


The initial margin for cleared contracts varies by the contract type and the clearinghouse. Moreover, the details of the margin model for OTC cleared contracts are prescribed under the Dodd-Frank Act and similar reforms around the world.


Collateral Management Model

Collateral Management Model

Although collateral management is broadly used to refer to the overall process, it is quite commonly used in the OTC bilateral market. As discussed in the blog, the Dodd-Frank Act and major global derivative markets have introduced new margin requirements for OTC bilateral contracts. These new standards are more stringent than those that were previously in force on OTC markets.


As opposed to the margin model, the counterparty that is exposed to risk obtains the collateral from the other counterparty. However, in US markets, the requirements of collateral are prescribed by the appropriate regulators.


Furthermore, regulations prescribe the eligibility criteria of collateral that can be used by market participants. Typically, cash and highly rated securities are eligible collateral.


The commitments of both parties in a bilateral contract are frequently reciprocal so that each party is exposed to a default of the other. Hence, it is mostly a two-way model.



The following list briefly explains the steps in the collateral management process between two counterparties. Later sections describe each of these steps in detail.

At specified intervals such as daily, weekly, bi-weekly, or monthly (known as a collateral cycle), the following steps are performed by each party.


  • Update positions. At the end of each collateral cycle, portfolios are updated to reflect any new and closed positions and collateral postings.


  • Exposure calculation. Contracts under each agreement are subject to collateral and are evaluated (marked-to-market). Exposure is calculated using predetermined methods and current market values.


  • Collateral valuation. Currently held collateral is evaluated using the current market value.


  • Variation margin. All open positions are marked-to-market (mark-to-model in case of illiquid contracts), and the change in contract value from the previous collateral cycle is determined. The variation margin is settled between counterparties, and it is mostly netted with other collateral requirements.


  • Independent amount. Based on new exposure and the current value of collateral held, determine if additional collateral is required.


  • Margin call. If additional collateral is required after netting all the different amounts, send a margin call to the counterparty.


  • Collateral return. If excess collateral is being held, return the excess portion.


Collateral posting and disputes. The counterparty posts the requested collateral if it agrees with the valuation. If it disagrees with the value, a dispute is generated and is resolved bilaterally.


Reconciliation. Each party regularly reconciles margin calls and collateral positions (posted and held).


With time, the collateral requirement between two parties continues to change due to several factors including trading activity (new, termination, maturing contracts), change in the value of existing open positions from market movements, and the change in the value of collateral being held.


The following sections explain different aspects of the collateral management process.


Valuation and Exposure


Liquid OTC bilateral contracts are evaluated using available market data from predetermined sources. However, exotic or bespoke bilateral contracts are evaluated using complex models.


In most cases, underlying valuation models, data sources, and all other required resources for valuation and exposure calculation are specified in the agreement or through market practices.


For an OTC bilateral contract, exposure is a complex measure. However, for the sake of simplicity, counterparty credit exposure is a measure of the amount that would be lost in the event that a counterparty defaults or fails to fulfill the obligation.


In general, exposure at any point in time is the replacement cost, which is the greater of the fair market value of the contract and zero. This is commonly used to measure credit exposure.


Furthermore, it may swing to any side as the market variables change. The commitments of both parties in a bilateral contract are frequently reciprocal so that each party is exposed to the default of the other. Hence, the counterparty risk is a risk to both parties. Consequently, all parties are involved in managing the collateral.


Another important point to consider is the netting agreement between counterparties. Netting agreements are risk mitigation tools built into most derivative contracts.


This agreement enables the aggregation of contract exposure between two parties, in which the positions with positive value can be used to offset the positions with a negative value. So, from a given counterparty, only the net positive value represents the credit exposure at the time of default.


Furthermore, details on exposure calculation vary by contract type and are beyond the scope of this blog.


Collateral Types

Collateral Types

There are two types of collateral that are exchanged between counterparties: the independent amount and the variation margin. These are considered in the following sections.


Independent Amount

Similar to the initial margin in listed and cleared products, the independent amount (IA) is an initial deposit required by counterparties to enter into the contract. Like the initial margin, the key objective of an IA is to provide additional collateral to protect against changes in the market value of the contracts between collateral processing cycles.


The required IA is computed by a predetermined model for a given contract and counterparty. Typically, the IA is posted by one or both parties on or before the execution of a contract and is expressed as a fixed currency amount, a percentage of the notional principal amount, or a computation of Value-at-Risk (VaR) of a contract or portfolio.


Moreover, the preferred models, the timing of a posting, and the operational details about IA are prescribed by the respective market regulatory rules.


Variation Margin or Mark-to-Market Exposure

Market Exposure

As for listed or cleared contracts, the variation margin (VM) is a change in the value of the contract from the previous collateral calculation cycle. At the end of each collateral cycle, all open positions are marked-to-market using the agreed valuation model.


The difference between the previous cycle and the current cycle is the variation margin or mark-to-market exposure. The full variation margin amount is exchanged between counterparties.


The valuation of a bilateral contract may be a complex process due to the custom characteristics and complex structure of these contracts. The first step of the margin call process is the acceptance of the valuation and the corresponding exposure by both parties. It is possible that one may not agree with the valuation of the other party, engendering a margin call dispute.


But this kind of dispute is resolved through direct communication. Moreover, it is critical that disputes are resolved in a timely fashion in order to avoid any counterparty credit exposure.


Collateral Asset Valuation

Collateral Asset Valuation

At the time of exposure calculations, any currently held collateral is also evaluated using current market prices (official market prices) to determine the fair value of the assets that are held. In the case of non-cash assets, the market value is discounted, which is explained below.



In the case of non-cash assets (securities), typically the market value is discounted by a predetermined percentage. This percentage is known as the haircut, discount, or margin.


The haircut depends on the nature of the collateral asset. Cash will have a haircut of zero percent because such collateral is the safest and easiest to liquidate in the case of default.


A haircut is applied to provide some level of safety margin to accommodate possible fluctuations in the value of collateral between two margin calls. For instance, a 15% haircut on specific security with a market value of $100 is valued at $85 ($100 - $15).


The haircut may also depend on the nature and credit rating of the issuer. However, a haircut by asset type is predetermined and is included in collateral agreements.


Eligible Collateral

The list of eligible asset types, applicable haircuts, and other details of collateral that is accepted are defined in a collateral agreement. In most derivative transactions, only cash and high-grade securities (highly rated securities of selected issuers) are acceptable as collateral.


Margin Call Generation

Margin Call Generation

At the end of each collateral cycle, each party evaluates the contract to determine the exposure and evaluates the current collateral to determine its fair value.


The independent amount is computed using agreed upon models. Variation margin is the difference between the current value and the previous value (collateral cycle) of the contract. All these values are netted and a single margin call is raised at each agreement level. Also, the margin call includes any interest and fee payments.


If excess IA is being held and/or VM is negative, the margin call (anticipated margin call) is expected from the counterparty to return. The party expecting excess IA typically sends an IA return notice. Regardless of the communication protocol, IA and VMs are exchanged between counterparties as scheduled.


Typically, a margin call between two parties is for the netted single amount, intended to reduce the number of transactions. The margin call received from the counterparty is compared with an anticipated margin call before processing.


In addition, anticipated margin calls provide an estimate on collateral obligations of the firm. Additional features of margin calculation are explained below.


Threshold Amounts

Threshold Amounts

In the process of determining the actual collateral requirement, minimum amount thresholds are used to avoid collateral movements of small values.


The threshold amount is an unsecured credit exposure that the parties are willing to accept before asking for collateral. In general, threshold amounts are set at relatively low levels in order to minimize credit exposure.


Thresholds are usually set for the independent amount and variation margin.


Minimum Transfer Amount

Minimum Transfer Amount

To prevent a small amount of net collateral transfers, a minimum transfer amount (MTA) is set in each agreement. Margin calls are not issued for the collateral requirements that are smaller than the MTA.



The collateral agreement may also include rounding rules (either up or down) that will round a collateral amount to avoid uneven amounts of exchange.



In the case of securities deposited as collateral, either party may request the substitution of those securities. In substitution, original securities will be replaced with another asset (securities or cash) of equal value.


Securities are substituted for various reasons such as securities rating falling below the acceptable limit making them ineligible as collateral or the owner would like to use them for other business purposes.


Dispute Handling and Resolution

If a counterparty does not agree with the amounts mentioned in a margin call, a dispute is created and is bilaterally resolved. In most cases, disputes are caused by the difference in exposure and collateral values calculated by both parties. These differences generally occur due to the data sources used for the valuation of a contract and/or collateral.


Reconciliation and Reporting


At the end of each business day or collateral cycle, a collateral management team generates various reports including a daily margin report, reconciliation reports, dispute reports and others for management, corporate treasury, and so on. In addition, this team reconciles contracts and collateral positions (held and pledged) of all the counterparties.



In OTC markets, it is general practice to use the collateral posted by the counterparty for pledging and repledging to other counterparties or any other business purpose.


This is known as rehypothecation right. Typically, dealers reuse collateral posted by their clients for other business purposes. However, this is done with the permission of the owner of the collateral assets.


According to new regulatory rules, rehypothecation of collateral is not permitted. This rule was triggered by some of the high-profile dealer failures during the recent financial crisis.


Legal Agreements and Documentation

Legal Agreements

In a bilateral market, trading partners negotiate and execute a legal agreement before or on the initiation of the contract. Typically, ISDA’s Credit Support Annex (CSA) is used in bilateral derivatives trading.


This agreement specifies the terms for the calculating and posting of collateral by each party to cover counterparty exposure as well as all the collateral management details. ISDA’s CSA has been amended to include new regulatory requirements in respective markets.


The collateral agreement is also known as the Collateral Support Document (CSD). All legal agreements between counterparties are subject to local jurisdictional and legal restrictions. Each participant executes the agreement with every other party that it trades with.


In addition to bilateral collateral agreements, participants may also use a tri-party collateral agreement that allows for a third-party custodian for the safe-keeping of collateral.


Portfolio Margining and Netting

Portfolio Margining

To optimize the collateral (initial margin or independent amount) required for participation in the derivatives market, markets have been using several margin calculation models that aggregate positions as a group or portfolio. The objective of the aggregation is to use appropriate levels of margin.


This means determining the lowest possible amount of collateral that is sufficient to cover the counterparty risk in case the counterparty defaults. Portfolio margining and risk-based margining are popular models that are widely used by most clearinghouses.


In a risk-based model, margin requirements are set by the largest possible decline in the net value of the portfolio that could occur under predetermined market conditions. This is considered the most appropriate collateral.


Another model in use is a strategy-based margining in which margin requirements are set by standard strategies used in portfolios, which are based on the idea that the potential loss from some positions is offset by gains on other positions.


Likewise, clearing members also use several models to optimize the required collateral from their clients. For instance, the common models used by clearing members are cross-product margining or cross-margining, which combines the contracts of different product classes of a client to reduce the overall required margin.


There is another practice known as cross-business exposure netting in which the exposures from different accounts or business lines of a single entity are combined to determine the overall exposure. This may optimize the margin requirements of the firm at a higher level.


Furthermore, portfolio margining procedures are done at a clearing member firm or on a CCP level for the positions held at these entities. If any client is using multiple clearing members and contracts are cleared by different CCPs, these optimization techniques would not be beneficial.


The portfolio margining or aggregating positions are allowed by netting agreements that are built into the derivatives contract in most cases. However, these institutions are allowed to use optimization models that are designed in accordance with the applicable regulations.


Collateral Custody

Collateral Custody

There are large amounts of initial margin and an independent amount (collectively, collateral) is transferred among market participants and CCPs in derivative transactions. This collateral is simply a deposit that is returnable and is held for the purpose of security.


There is a risk of losing this collateral in case of any default that may also impact the overall system. Hence, over this period, regulations have improved custody rules to protect the collateral posted by market participants.


Listed markets have relatively safe custody rules. In OTC markets, however, collateral custody rules have been enhanced due to some of the major failures in the last decade. Essentially, the regulatory rules enforce safe custody of collateral across the board.


Custody rules of collateral are prescribed by respective regulators. In general, listed markets are governed by a different set of rules than OTC markets. Overall, regulators create rules on how customer funds are maintained by clearing members in different scenarios.


A clearing member maintains multiple accounts for each client, separated into listed contracts traded on domestic exchanges, listed contracts traded on foreign exchanges, and cleared contracts cleared by the Designated Clearing Organization (DCO). The separation usually follows regulatory requirements.


Listed Transactions

Listed Transactions

In the case of listed transactions, all funds deposited by customers are required to be segregated and are not allowed to be used to cover obligations of other clients or the clearing member (CM or FCM) itself. All of these funds are held in a bank account, trust company, DCO, or another clearing member.


Furthermore, all customer funds may be commingled in a single account, known as an omnibus account, with beneficiary (customer) information properly tagged. An omnibus account is a special type of account that holds money and securities owned by more than one party (beneficiaries) but under one account holder, such as FCM or a broker.

Regulatory rules also prescribe custody requirements in case contracts are cleared by foreign clearing members and other related situations.


Cleared Transactions

In the case of cleared transactions, collateral deposited by customers is held in a separate account in accordance with rules prescribed by applicable clearinghouses. Furthermore, these funds are allowed to be commingled in a single omnibus account, as explained above.


Moreover, in the United States, the Dodd-Frank Act prescribes collateral segregation rules through standards known as Legal Segregation with Operational Commingling Model (LSOC) on how to handle the collateral from cleared contracts.


Bilateral Transactions

Bilateral Transactions

In the case of bilateral transactions, recent regulations across the global markets prescribe stringent collateral management rules. In respect to the custody of collateral, rules require that an independent amount (collateral) must be segregated from the rest of the assets because it is more like a security deposit.


In addition, if a collateral owner desires, it must be held at an independent­ third-party custodian. In such cases, collateral is held at an independent third-party custodian through a tri-party collateral agreement. This custodian is also referred to as a tri-party collateral agent. Furthermore, rehypothecation of this collateral is prohibited.


In respect to collateral posting requirements, regulations prescribe rules based on the type of the participant—SD, MSP, and EU. In general, for a transaction between SDs, between MSPs, and between an SD and an MSP, both parties must post collateral to cover IA.


For transactions between SD or MSP and an end user, only end users are required to post collateral to the counterparty (SD or MSP are collateral holders).


In addition, rules also impose restrictions on the type and quality of collateral that can be pledged as well as the timing of the posting of collateral in bilateral transactions.




A designated Self-Regulatory Organization (SRO) conducts periodic audits of clearing members to confirm that customer funds are being held in properly designated accounts and other operational requirements. In addition, firms also employ an internal audit group that monitors compliance and regulatory requirements.


Interest Payments and Fees

Interest Payments

As stated earlier, the initial margin and independent amounts in the form of cash earns interest for the owner. Interest payment cash flows are processed and reconciled by respective parties.


CCPs charge a clearing fee to their customers and, in turn, a clearing member charges a clearing fee to its customers. In addition to a clearing fee, usually, a service fee and other types of fees may be involved in collateral management.


Netting and Settlements

Typically for each account or agreement, only one margin call is raised combining all types of margin or collateral requirements—such as IM, IA, VM, fees, and interest payments. In addition, multiple payments between two entities may be netted to achieve a single transaction or the fewest possible transactions.


As explained above in the “Process” section, collateral transactions also go through the approval process (via the back office) and settlement instructions are sent for final processing.


Risk Management

Risk Management

Although collateralization is used for risk mitigation, the process itself introduces some risk that needs to be managed separately. Typically, those risks are the following:


  • Operational risk. The overall process needs to be managed efficiently, including valuation, exposure calculation, collateral calculation, margin call processing, and reconciliation. Any operational failure or incorrect calculation may introduce a shortfall in protection or capital management issues.


  • Residual credit risk. Residual credit risk may arise from the falling value of collateral securities in case of default or other such events.
  • Concentration risk. The risk from collateral assets that are concentrated such as on the same security, issuer, type of asset, or country.
  • Legal risk. Collateral and default governing laws vary by jurisdiction. The collateral agreements spreading across different jurisdictions introduce legal risk.
  • Liquidity risk. Quick market downturns or other such events may introduce liquidity issues of collateral assets.


Enterprise Collateral Management

Enterprise Collateral Management

After the Dodd-Frank Act and other similar global reforms, the demand for collateral has increased to greater levels across the board. Regulations also enforce stricter eligibility criteria, which further increases the demand for higher quality collateral.


There has been a lot of attention for financial institutions and corporations to optimize the collateral usage at the enterprise level.


In addition to a derivatives business, typically firms use collateral in other business lines such as lending, borrowing, repo trading (repurchase agreements), and securities trading and lending. As a result, it is crucial to manage the inventory efficiently and to use the best optimization program to manage the firm’s capital efficiently.


Optimization is the process of identifying and using the most cost-efficient asset to pledge as collateral. If this is done at an enterprise level across multiple business lines that require collateral, it is referred to as Enterprise Collateral Management (ECM).


ECM requires firms to manage their available pool of assets efficiently in order to achieve a better enterprise-wide view of their collateral along with an enterprise-wide view of liquidity and counterparty credit risk.


In each business line, collateral, risk, and trading teams must work together to identify the right asset to use or receive as collateral for each trade. Additionally, an ECM function will need greater integration of treasury and risk functions with the front offices of all business lines.


Essential components of the ECM are the following

Enterprise-wide inventory management. Comprehensive firm-wide, real-time inventory management can use a central database of collateral available to pledge as well as the collateral that is posted and received.


  • Enterprise collateral management. Efficient allocation and tracking of collateral at an enterprise level. It includes managing inventory across multiple business units, counterparties, and clearinghouses.


  • Enterprise technology platform. An integrated technology platform that supports end-to-end collateral management functions to run the processes, including valuation, margin calculations, document management, workflow management, and settlement management, to reduce the operational risk and to meet enterprise-level objectives.


  • Collateral optimization. Efficient optimization algorithms that identify eligible and cost-effective collateral to pledge and maximize return on assets while monitoring risks such as a concentration risk.


  • Compliance. Enterprise collateral management platforms need to support local and global compliance rules, such as Dodd-Frank and EMIR and easily adapt to changing regulatory demands.


  • Integrated platform. Tight integration of collateral management components of other business lines, treasury, and risk management systems are needed to provide holistic management of enterprise collateral.


In summary, ECM is a complex task and requires a state-of-the-art technological platform that incorporates the above-mentioned features, enabling efficient inventory management and collateral optimization.




Collateralization is an essential tool for promoting safer derivative markets. Collateral management has assumed an important function at the derivatives business level as well as at the enterprise level for most financial and non-financial institutions. In recent years, derivatives markets—especially OTC markets—have gone through major reforms.


Derivative transactions are broadly divided into two categories: centrally cleared and bilateral. In a cleared market, CCPs play a major role in promoting a safer market through an efficient collateralization process.


In OTC markets, recently imposed regulatory regimes (Dodd-Frank and similar) promote safety through the introduction of additional collateral requirements, collateral protection rules, and other rules to mitigate the exposures that intensified the recent market crisis.


This blog described the collateral management function in centrally cleared markets and bilateral markets. Finally, it introduced enterprise collateral management and essential elements contributing to this emerging initiative.


Each of the remaining blogs in the third part of this blog focuses on a specific product group. Together they flesh out the derivatives contract lifecycle with product-specific collateral management functions.


Futures Workflow


Futures are widely traded instruments in listed markets. The key players in the listed market are end-clients (institutions, retail customers), Futures Commission Merchants (FCMs, also known as brokers), exchanges, and clearinghouses. In futures trading, the FCM acts as both execution broker and clearing member. 


Key steps in the futures trading workflow include the following:

  • Clients (trading parties) submit their orders to their respective brokers (FCMs).
  • The FCM identifies the trading venue (exchange, market-making platform, or other; ) and sends the client order for execution. The order is executed (filled) on the execution venue.
  • Execution information is sent to the FCM and in turn to the client.


The FCM confirms the trade and then clears it with the clearinghouse. The clearinghouse clears (novation) the trade and updates both FCM margin accounts (an initial margin is required for the new trade).


The FCM updates the client’s margin account

client’s margin account

  • At the end of day, the clearinghouse prepares a position report and margin requirements if any (margin call) and sends it to all FCMs.
  • The FCM reconciles and updates its own blogs with the clearinghouse. It also deposits additional margin with the clearinghouse, if required.
  • The FCM then generates a position and margin report and sends it to its clients. The client will then reconcile and deposit additional margin with FCM if required.


Margin management continues every day until there are no open positions. Every day, each open position requires a minimum margin to be maintained and for the profit or loss of the day to be settled. The client may exit the position by offset trade. The position will be closed after the settlement of final profit or loss.


If it is a delivery contract and the position is not closed before the delivery period, it may result in delivery. The clearinghouse issues a delivery notice to the FCM and to the client. The client then processes the delivery of the underlying contract.


Each of these steps is discussed in the following sections


Contract Life Cycle

Contract Life Cycle

The following sections presume knowledge of the information and highlight only information that is specific to the phases of the futures contract lifecycle.



Pre-trade involves the setup of a legal relationship among all market players. For futures trading, clients follow the listed market onboarding procedure, whose essential points are discussed below.


Onboarding and Compliance

Because futures are listed products and traded on exchanges, there are no significant differences between the onboarding process for the future. Clients establish a legal relationship with FCMs using standardized agreements.


FCMs obtain and maintain membership on clearing-houses and exchanges. Exchange markets are regulated by governmental agencies (for instance, CFTC in the United States) and market associations (for instance, NFA in the United States).


FCM and Clearing Member

An FCM acts as a broker for all its clients to execute futures trades on an exchange and maintain margin accounts. In the futures market, FCMs provide both execution and clearing services to their clients.


As noted earlier, they are also known as simply brokers. An exchange rule blog is the best resource for understanding the full details of registration and all other procedures.



Futures are traded on derivative exchanges around the world. Because futures are among the oldest form of derivatives, contracts are available on a large number of asset types, including various financial indices.


Each contract is specific to the exchange, and contract terms are set by the listing exchange. Exchanges generally employ an electronic trading model, but there is still some pit trading.


Futures trading follows an anonymous exchange trading model in which buy and sell orders from two different parties are matched anonymously and then cleared by the clearinghouse. After the trade is cleared, each contract holder’s counterparty (faces) the clearinghouse instead of the initial trading partner.


Institutional clients trade futures through either of the two following channels:

Through an FCM (broker)—executed on the exchange pit or an electronic system Direct with exchange—electronic platform


A futures trade requires the following key information:

  • Contract Identifier—Each contract has a unique identifier.
  • Quantity—The number of contracts. Each futures contract represents a predetermined quantity (standardized) of underlying. For instance, one corn futures contract may represent 5,000 bushels of a specific type and quality of corn.


  • Buy or sell—Representing whether to buy or sell the underlying Other information such as order type (market order, limit order) and opening or closing a position


Futures Instrument Identifier Because a large number of futures instruments are traded on each exchange, each instrument is assigned a unique identifier. Each exchange uses a specific symbology to assign identifiers. 


Futures Quotes

A futures contract price is the price of the underlying to trade on a future date specified in the contract. By contrast, a spot price is a price to trade the underlying right away.


Key elements of futures quotes are the best bid (highest price), best ask (lowest price), and last trade price and quantities. Detailed quotes include other details such as last sale time, change, and open interest.


Exchanges stream quotes and execution prices throughout the trading day. At the end of the trading day, they publish closing and settlement prices of each contract. Futures are settled using a settlement price, as explained below.


Closing Price versus Settlement Price

Settlement Price

A settlement price is an official price determined by the exchange at the closing of trading. It is used for the purpose of evaluating a contract to calculate gains, losses, and margin amounts. Each exchange specifies a clearly defined formula that they use to determine the settlement price.


Generally, the settlement price is an average of a few transaction prices immediately before closing or the average of indicative quotes obtained from traders at the closing. Sometimes settlement price is also referred to as official quotation or simply market price. 


The closing price of a contract is simply the last trading price of that business day. The next business day, trading starts at the closing price of the previous business day.


Exchange Trading and Controls

Exchange Trading

Because the futures market is filled with speculators and professional day traders, exchanges place some controls such as price limits on trading to avoid extreme price movements.


These controls safeguard investors from the substantial losses that may result from major events affecting the market’s sentiment or from manipulation, abuse, or technical glitches.


Every contract has a price limit set as part of its specification. The price limit of a futures contract is the maximum amount the price can move in one day. Price limits are usually set in absolute dollar amounts. For instance, if the price limit is $5 of a specific contract, this means the price of the contract cannot increase or decrease by more than $5 in a single day.


When the trading price reaches this limit, exchanges take certain actions such as halting the trading or freezing the price. The actual practice varies by rules set by the exchange.


Post-Trade Processing

Trade Processing

After the execution, trades must be confirmed and cleared before they become live. In the futures market, post-trade processing is done electronically. Since the trade is executed on the exchange (mostly over electronic systems), trades are processed much quicker and with the least number of errors. Exchanges and clearinghouses provide direct access to their systems to submit trades, enabling STP across the board.



If the order is not is allocated before the execution (pre-trade allocation), the client must allocate the order after the execution (post-trade allocation).


Confirmation and Clearing

After execution trades are submitted to the exchange for confirmation, they go to a clearinghouse. After clearing, both parties are legally obligated to the contract.


Live Contract

Live Contract

A futures contract becomes effective (live) after clearing. Futures are standardized contracts and their provisions may not change during the terms of the contracts. Because futures contracts are traded on the open market, their prices are driven by demand, supply, and other market factors.


The exchange is responsible for administering the contract, and the clearinghouse is responsible for margining through its members. An open position can only be closed (offset) when a client wants to exit, and it cannot be altered during its term. A position can be held until the end of the term (to maturity), as explained in the following section.


One contract is the minimum quantity that can be traded, and it represents a specific amount of underlying. Clients can open and close any number of contracts as required.


Initial Deposit

Initial Deposit

When a position is opened, an initial margin amount must be deposited (with-drawn from margin account) and it will be refunded when the position is closed.


Daily Settlement or Marking-to-Market

Futures are margined products, such that contract values are not exchanged. Instead, each open position is marked-to-market and settled daily at the clearinghouse or FCM.


At the end of each business day, the gain or loss is calculated against the settlement price. At an FCM, the calculated gain or loss is added to or deducted from a client’s margin account. Similarly, at a clearinghouse, each FCM’s account is updated with gain or loss.


This is also known as the marking-to-market of futures. Thus, the change in the value of each open futures contract is settled daily. This is equivalent to terminating a contract at the end of each day and reopening the next day at the previous day’s settlement price.


This unique characteristic of futures contracts confers these products with great flexibility and liquidity.


Corporate Actions

Corporate Actions

If any corporate action such as a stock split or merger affects the underlying asset of the futures contract, the futures contract will be affected. The operations team, with the advice of the FCM and clearinghouse, will adjust futures positions to reflect such changes.


For example, suppose that a futures contract for 100 shares of ABC stock is priced at $50 and that the stock splits 2 for 1. The clearinghouse thereupon adjusts the size of the contract to 200 shares and the price to $25. Other contract characteristics impacted are similarly adjusted to reflect the stock split. Such adjustments apply to all open contracts.


The clearinghouse then issues a notice with details to all parties. However, on the exchange, the new contracts are issued at the standard size of 100 shares, which trade at the new price of underlying.


Offset or Close-Out

A futures contract position can be closed before its maturity or it will terminate upon maturity resulting in delivery if it is a delivery contract. Any open position can be closed by trading a contract and quantity in the opposite direction.


For instance, assume there is an open position such that one contract is expiring in September to deliver (sell) corn. In other words, this position was opened in the past by selling one contract of corn with September delivery (known as a short position).


To close this position, a holder must trade one contract expiring in September in order to receive (buy) at a prevailing price. In other words, now he must buy one contract of corn with a September delivery (long position). This trade is called an offset or reversing trade.


An offset trade is purchased at a certain price during the day and will still result in a profit or loss on that day. This profit or loss will be determined by the difference between the previous day’s settlement price and the price of an offset trade. Suppose that the opening price (the previous day’s closing price) was $50 and at the time of offset trade execution it was $48.


The difference of $2 is settled at the end of that day regardless of the closing of that day. In this case, a long position holder loses $2, and a short position holder gains $2.


Settlement on Maturity

Settlement on Maturity

Futures are settled daily, meaning that a contract on any given day has an obligation from just that day’s price change (the difference between the closing price of the previous day and current day).


If the contract is terminated on a specific day, the settlement at the end of that day fulfills its obligation (the profit or loss is settled). In the case of a cash-settled contract, it is simply terminated or dead after the final settlement.


In the case of a physical delivery contract, upon maturity (assignment) the physical delivery process will start. The major distinction between cash-settled and physical-delivery contracts lies in the final stage known as the delivery month, discussed later in this blog.


Futures Rolling

All futures contracts expire on a predefined date. If contract holders elect to continue to hold their positions, they have to offset their current position and buy a new contract before the current contract expires. These two trades are typically done in one step, known as a roll trade.


Most futures contracts have a specific rollover day. The day after the rollover day, old contract trading stops and new contract trading starts. The rollover day is typically a few days prior to the actual expiry day of the contract. The exchange sets the rollover day for each contract.

An expiring contract is referred to as the outgoing contract, whereas a new contract superseding it is referred to as the incoming contract.


Contract Timeline

Contract Timeline

The timeline is important to understanding the life cycle of a futures contract.


The following are the two main stages in a futures contract’s life:

Trading period. A period of time during which market participants can enter the contract and close out the open contracts.


Delivery month. A period of time during which the assignment, delivery of underlying, or settlement of a contract takes place. Typically, major parts of the futures contract positions are closed using offset trades before maturity without resulting in delivery. 


Each of the milestone days is explained below. The actual dates and details of each milestone are defined by the exchange for each contract they trade.

Inception date

Inception date. Trading of the contract starts from the inception day.


Expiration date. The contract expires on this day resulting in a final settlement of either cash or delivery based on the definition if it is held until the expiration date.


Trading period. The contract can be traded through the trading period.


A delivery month or contract month. The month in which delivery of the underlying is supposed to happen. Some futures contracts define a delivery month and the underlying can be delivered during any day of the delivery month.


Delivery day. A specific day in the delivery month on which underlying must be delivered, if the contract is not closed before that. Some futures contracts define a specific delivery day of the delivery month instead of the whole month.


First, notice day. A party with a short position issues a notice of delivery, usually a few business days prior to delivery (based on the settlement terms). The delivery day can vary between the first business days of the month to the last delivery day in the delivery month. But, notice has to be given on or before the last notice day.


Last notice day. This is usually a few days prior to the last trading day or the last trading day itself. In case it is defined as the last trading day, the actual delivery happens after the last trading day. It may simply vary by contract.


Delivery notice period. The period between first notice day and last notice day.


Last trading day. The final day as per the contract terms that a futures contract may trade or be closed out before delivery of the underlying asset or cash settlement must occur. By the end of the last trading day, if the position is not closed, the contract holder must be prepared to settle through the delivery using delivery terms.


Delivery and Settlement

When a futures contract matures, the trade has to be executed or settled as the transfer of the underlying between two parties according to the terms of the contract.


That means the holder of the short position must deliver the underlying to the long position holder. This is known as a futures delivery. Futures delivery is defined to be as either cash-settled or physical delivery. Delivery starts with the assignment, as explained below.




A short position holder may offset with long trade any day until the last trading day. However, if a short position holder decides to deliver, they must issue the delivery notice during the delivery notice period.


The notice period starts a few days before the beginning of the delivery month and ends just a few days before the end of the delivery month to allow the clearinghouse to process the delivery notice. The clearinghouse then assigns delivery to one of the long position holders.


As it receives notices from short position holders, the assignment process continues throughout the delivery period. In addition, on the last notice day, all open long positions are matched with open short positions and delivery is assigned.


Thus, all open contracts are settled by the end of their term. The clearinghouse issues the assignment to an FCM, who conveys it to one of its end-clients. The actual assignment methodology is defined by an exchange for each product.


Note that a long position holder may be assigned the delivery any time during the delivery month or at the end if the position is still open. 


Cash Settlement

Cash Settlement

To repeat, futures contracts are margined, meaning that the profit or loss is settled daily although the contract stays open (life) until offset or matured. This settlement continues until the last day of the contract. Cash-settled futures contracts can be traded until the last day of the contract on the last trading day.


On the last trading day, the settlement price is set to equal the cash price of the underlying asset. Based on this settlement price, a final margin payment is settled and then the contract expires.


Physical Delivery

There are futures contracts on a variety of underlying assets such as financial securities (stocks, bonds), commodities (gold, silver, soft cocoa, and so on), currencies, and interest rates. While most are cash-settled, some require delivery of the underlying. The following steps summarize the various stages in the delivery process:


  • Delivery notice. A short position holder issues a delivery notice to its broker during the delivery notice period. The broker then sends the notice to the clearinghouse.


  • Assignment. Upon receiving the notice, the clearing-house selects one of the long position holders and assigns the delivery. Long position holders are chosen by the exchange using specific criteria that varies by exchange.


  • Asset delivery. As per the terms specified in the contract, the delivery process takes place. If the last notice day falls on the last trading day, then delivery happens after the last trading day.


  • The contract specifies delivery details such as the delivery month, delivery day, acceptable delivery location, acceptable asset quality details, and all other conditions of delivery.


  • Delivery period. Some contracts define the delivery month while others define the specific day of delivery in the delivery month. In the case of the delivery month, delivery can happen on any day of the month. In the case of the delivery day, contracts are settled (delivery must happen) on that specific day.


  • Trading period. Trading continues until the last trading day, as defined. If the position is not closed or not assigned a delivery by then, at the end of the last trading day all open contracts will end up in delivery. That means all long positions are assigned to short positions. Then the delivery process takes place.


  • Last trading day. Typically, the last trading day falls in the delivery month toward the end of the month or on the last day of the month as specified in the contract.


  • For instance, the last trading day of the CME futures contracts is two business days prior to the third Wednesday of the delivery month. Final settlement happens on the third Wednesday (as per T+2) settlement.

Some exchanges also have alternative delivery options known as an exchange for physicals, explained in the next section.


Exchange for Physicals

Exchange for physicals (EFP) is an alternative option to a physical delivery process. The contract defines characteristics of the asset to deliver including the location. As an alternative to the defined underlying, a short party may get into an agreement with a long party for an EFP option.


In this process, both parties privately negotiate delivery details and inform the exchange to close their positions. An EFP option may not be available on all exchanges and when available, actual details may vary by exchange.


Delivery Differentials

Sometimes the quantity and quality of the delivery asset may not exactly match the quantity and quality as specified in the contract. In such cases, short parties are given an option to deliver nonstandard assets at nonstandard delivery points.


However, they may have to pay a surcharge known as a delivery differential. This surcharge reflects the differences in the quality of the delivering asset and location of delivery, and its imposition is common practice in commodity futures.


Margining Process

Margining Process

As noted there, a client maintains a margin accounts with an FCM, while an FCM account is maintained with a clearinghouse.

Each trade’s opening position requires an initial margin equal to the amount specified in the contract. This amount is deducted from a margin account. Similarly, a closing position will initiate the refund of the initial margin.


At the end of each business day, a position is marked-to-market and the resulting profit or loss is added (credited) to or deducted (debited) from a margin account. The value change (gain or loss) is known as a variation margin, variation, settlement variation, or mark-to-market amount.


The impact of a new trade on accounts (variation margin) could be as follows:

If a client buys (long position) a futures contract and the price of the underlying goes up, the client’s gain will be the amount of the price increase times the contract size.


If a client buys and the price goes down, the client’s loss will be the amount equal to the price decrease multiplied by the contract size.


If the client sells (short position) a futures contract and the price goes down, the client’s gain will be the amount of the price decrease multiplied by the size of the contract.


If the client sells a futures contract and the price goes up, the client’s loss will be the amount of the price increase multiplied by the size of the contract.


Thus, the values of all open positions and initial margin adjustments from the day’s trading activity are processed to identify the margin account balance. If the balance is below the minimum required amount, a margin call is issued.


When the position is offset on any given day after that day’s margin (profit or loss) settlement, the contract is terminated. 

SPAN Standard Portfolio Analysis of Risk (SPAN) is a margining method introduced by CME and used by many clearinghouses today. This method computes the initial margin requirements for a whole derivative portfolio based on price and volatility changes.


Intraday Margin On high-volatility days and for certain products, some clearinghouses use intraday margining. Instead of at the end-of-day, a clearinghouse computes the margin during the day and issues margin calls to reduce its exposure.


In a high-volatility situation, they may even increase initial margin levels above normal, requesting additional deposits from clients. It is also possible that an additional margin is requested only from one side (long or short) based on the price movement.


End-of-Day Activity

The following sections summarize the end-of-day activities of each key player.



The clearinghouse maintains the FCM accounts and is responsible for processing all transaction. The key end-of-day activities are the following:

  • Publishing closing and settlement prices
  • Updating margin accounts of each FCM
  • Applying initial margin for new and closed positions
  • Applying gains and losses after valuing (mark-to-market) of all positions
  • Closing all offset and expired positions
  • Sending margin account details to all FCMs
  • Issuing margin calls to FCMs as required
  • Processing all delivery notices and issue assignment notices
  • Reconciling due collateral from the past 



  • Updating closing and settlement prices for all futures contracts
  • Updating margin accounts of all clients’ and house accounts by
  • applying initial margin for new and closed positions
  • mark-to-market all positions and apply gains and losses
  • Closing all offset and expired positions
  • Clearinghouse accounts—reconciling accounts and margin calls with clearinghouses
  • Client accounts—sending account updates (reports) to all clients
  • Issuing margin calls to clients, as required
  • Processing delivery notices and issuing assignment notices
  • Posting due collateral to clearinghouses
  • Reconciling due collateral from clients


Buy-Side (End Client)

  • Updating the closing and settlement prices of futures contracts for all their positions
  • Mark-to-market all open positions
  • Closing all offset and expired positions
  • Reconciling positions and margin accounts with FCMs
  • Posting collateral to FCMs (process margin calls)
  • Processing delivery and assignment notices