Earlier today, the CFTC’s Division of Clearing and Risk issued an interpretation stating that, “variation margin (‘VM’) payments and all other payments in satisfaction of outstanding exposures on counterparty’s cleared swap positions constitute settlement of the outstanding exposure and not collateral against it.”  The practical effect of this interpretation for derivatives clearing organizations is that they will need to ensure that their rulebooks reflect that VM payments constitute settlement of outstanding exposures, rather than collateral.

For buyside firms, the interpretation presents an opportunity to once again reflect on the not-so-intuitive use of the term “margin” in the context of the trading futures contracts and cleared swaps.  In everyday usage, market participants use the terms interchangeably to refer to the posting of assets to secure the future payment obligations of the parties.  As a technical matter, the two terms have more nuanced definitions:

  • Initial margin is often described as “a good faith performance bond,” that is tied to the overall volatility of the particular underlying and intended to ensure that a party will meet its obligations in respect of the derivative; and
  • Variation margin is the daily payment of obligations owed by a party as a result of the mark-to-market movement in value of the derivative relative to the previous day’s value.

For buyside clients, the practical implication of today’s interpretation is that it reaffirms that a futures commission merchant (FCM) can use proceeds from the payment VM obligations in running its business, subject to compliance with other applicable CFTC rules, since VM is the settlement of outstanding exposures (not collateral owned by the customer and in which the customer grants the FCM a security interest).  Thus, it becomes the property of the FCM and, if the FCM becomes insolvent, the customer will not be in a position to recover VM (since VM is not the customer’s property, but rather a payment by the customer for what it owed to the FCM).

This makes VM on futures and cleared swaps distinguishable from VM on uncleared swaps, since the latter does in fact constitute collateral rather than the settlement of outstanding exposures.

Good day. Good to keep in mind. DR2