A robust system of portfolio margining for futures and options

1
A robust system of portfolio margining for
futures and options
2
Principles
3
Design of the system main principles

• A required precondition for a risk free system
  usage of limits on futures prices fluctuation and
  the exchanges capability to control them. Using
  price limits makes possible building of a system
  completely covering the exchange against market
  and credit risks options and futures portfolio
  margin is to ensure 100 coverage of possible
  losses.

4
Design of the system main principles

• Acceptable level of margin in a normally
  functioning competitive market is ensured by the
  portfolio approach towards margining
• The new approach is in a milder regime for those
  participant who fail to meet the margin
  requirements. Their options portfolio is not
  liquidated, rather it passes under temporary
  control of the exchange that conducts correcting
  (hedging) of the portfolio through a number of
  futures operations according to pre-established
  rules.

5
Design of the system main principles

• All procedures constituting the system
  (corrective management procedure, procedure of
  liquidation) are to maintain systemic integrity
  of the market. In other words the exchange must
  not promote chain effect and cross-defaults among
  the participants.

6
Design of the system main principles

• Allowance for various scenarios of market
  developments, including full loss of liquidity on
  the futures market. Though for the developed
  markets the latter is hardly probable, for the
  Russian derivatives market it also have to be
  foreseen.
• Minimization of the impact on the market during
  the corrective management carried out by the
  exchange.
• Margin level requirements set by the brokers must
  be not lower those set by the exchange. The
  correctness of the margining is ensured by the
  decentralization (subadditivity) feature of the
  margin, provided by the systems construction.

7
What determines margin level requirements

• In any system the margin level depends on the
  method of corrective management of assignors
  portfolio carried out by the exchange.
• Standard approach liquidation of the positions
• Suggested approach
• retaining of options positions
• realization of corrective strategy

8
Method of guaranteed margin calculation

• In the system with fixed period of maintenance of
  assignors option positions margin is defined as
  a minimal amount required to cover all losses
  under the given portfolio in case of the
  participants default on the assumption that
• on daily basis the exchange conducts futures
  transactions at closing prices from the corridor,
  determined by the limits and the closing price of
  the previous trading day
• prices limits remain unchanged during the terms
  of the options

9
Functioning of the System
10
Placement of Orders by the Participants

• The main principle is to check real time every
  order if it is admissible with respect to the
  margin requirements. All possible variants of the
  portfolio composition implied by order execution
  should be considered.
• In admissibility verification not only the
  structure of the orders but also the current
  portfolio of the participant and the active
  orders must be taken into account by the
  exchange.

11
Procedure of participants margin deficit
reconciliation

• In case of margin deficit arising on the clearing
  account of a participant, the latter is given
  opportunity to restructure the portfolio o by his
  own or paying margin call so as to comply with
  the margin level requirements.
• Such restructuring can be conducted until margin
  requirements compliance is reached or until the
  time allotted by the rules of the exchange
  elapses.

12
Delegation of Rights to Manage the Portfolio to
the exchange

• In the event that the participant fails to
  reconcile the margin deficit within the allotted
  time, the right to manage his portfolio passes to
  the exchange and the given participant becomes an
  assignor
• Under the internal rules of the exchange the
  right to manage the assignors portfolio is
  delegated to the exchange, which effects
  corrective futures trades on behalf of the
  assignor according to a pre-established in the
  rules of the exchange algorithm

13
Portfolio passes to the exchange case of a
liquid market

• On passage of the management rights to the
  exchange, the latter conducts calculation of
  parameters of corrective control, which
  guarantees that the assignor will be able to meet
  all his obligations.
• To one step of corrective control corresponds one
  day.

14
Minimization of the exchanges impact on the
market initial period of control

• Conducting of futures transactions at market
  prices.
• Monitoring of the depth of the market is carried
  out in order to determine the price elasticity to
  the volume of the order.
• In case of high elasticity of market price from
  the volume of order, corrective orders are placed
  in small portions at market relaxation time
  periods.

15
Special (reverse) auction second period of
control

• Should the corrective management not be fully
  realised after the initial period of control,
  limited orders for futures are placed for the
  volume of the outstanding amount of corrective
  management volume.
• Price of the order is gradually changed in favour
  of the contractor right up to reaching the
  respective price limit.
• Trades, concluded within the second period of
  corrective management are not taken into
  consideration in calculations of the weighted
  closing price.

16
Compulsory conclusion of corrective trades
third period of control

• Should the corrective management be not completed
  within the second period, then one or several
  contractors are selected with whom compulsory
  trades are concluded, which will complete
  corrective management.
• This transaction is carried out in accordance
  with the respective limits under condition that
  the margin requirements to the contractors
  portfolio do not increase.

17
The case of non-liquid market

• In the event that it has been impossible to
  strike corrective trades at the available prices
  within the price limits, which indicate at full
  loss of liquidity by the market (reluctance to
  conclude deals at the most favorable prices, and
  in the case when no commission for the deals is
  collected, at superfavorable prices), then
• The price limits corridor is narrowed or the
  maturity is shortened
• If the previous measures are not success,
  immediate early execution of all outstanding
  contracts at the weighted average price for a
  specified period of time (last trading day, for
  example) is performed

18
Completion of the corrective management

• Corrective management is completed
• In the moment of execution of options contracts,
  or
• If the margin deficit is reconciled. The latter
  is possible
• as a result of corrective management conducted by
  the exchange, or
• in the event that the amount required by margin
  call is paid to the clearing acount.
• On the day following the day of margin deficit
  reconciliation the participant is returned the
  right to manage his portfolio.

19
Prerequisites of the system design philosophy
20
Gross-margining

• In gross-margining margin is being summarized by
  separate instruments
• One of the possible gross-margining schemes looks
  as follows
• long positions are evaluated as payoff functions
  (minimal possible non-arbitrage price).
• short positions are evaluated at maximum possible
  non-arbitrage prices (calcualated by a special
  algorithm)

21
Comparison with the gross-scheme

• Compared to the gross-margining scheme the margin
  level required in the described system is
  significantly lower

Blue line the function of payouts under the
portfolio Green line margining under the
described system Red line margining under
gross-scheme
Options for 3 futures Limit on price changes 20
kopecks To maturity 5 days
22
Liquidation of the portfolio. Example.

• The market is constituted by 3 agents holding the
  following portfolios
• 1. 1 long call 28.7
• 1 short call 28.9
• (Red line, the margin equals to 0, as there are
  no obligations)
• 2. 1 long call 28.9
• 1 short call 29.1 (Blue line, the margin is 0)
• 3. 1 short call 28.7
• 1 long call 29.1
• (Purple line)

Three open call options on the market with
strikes 28.7, 28.9, 29.1 Current futures price
28.95 (Green line)
23
Liquidation of the portfolio. Example.
The 3rd participant claims default. His
positions are closed. After the closing the
participants hold the following portfolios 1. 1
short call 28.9 (the margin grows to 1.83,
shortage of funds) 2. 1 long call 28.9 (the
margin is 0)
Conclusion the margin required for the closing
is high and comes close to the gross-margin
24
Drawbacks of standard models like Black-Scholes

• The Black-Scholes model provides quite precise
  tools to evaluate an options and futures
  portfolio in a sufficiently liquid market. On
  such market this allows to use such effectively
  functioning systems as SPAN, involving
  liquidation of the portfolio in case of a
  participants default.
• In real life the usage of Black-Scholes model is
  unrealistic, and it cannot be assumed as a basis
  of a guaranteed margining system.
• For example, the market of USD futures on the
  MICEX (Moscow Interbank Currency Exchange), as
  well as another Russian derivatives markets,
  Black-Scholes models cannot be conceived as even
  distantly applicable, in particular, because of
  low liquidity.

25
Demonstration of the systems functioning
26
Example of standard portfolio margining in the
described system
Options for 3 futures, limit of prices changes
20 kop. To maturity 5 days.

• Short call

• Bear spread

Blue line payoff function of the portfolio
Green line margin (with minus)
27
Example of standard portfolio margining in the
described system
Options for 3 futures, limit of prices changes
20 kop. To maturity 5 days.

• Butterfly

• Straddle

Blue line payoff function of the portfolio
Green line margin (with minus)
28
Example of standard portfolio margining in the
described system
Options for 3 futures, limit of prices changes
20 kop. To maturity 5 days.
Blue line payoff function of the portfolio
Green line margin (with minus)
29
Choice of specification influence of the volume
of options contract
Dark blue line payoff function Green line 1
futures in the contract Red line 3 Blue line
5 Purple line 10

• Dependence of the specific margin for 1 futures
  on the quantity of futures in the contract
  (non-homogeneity)

30
Features of margin as a function of the
portfolios parameters

• Dependence of the margin level on the quantity of
  futures (by the example of short call option)

• Dependence of margin on the number of days to
  maturity

31
Limits a tool to manage uncertainty

• Potentially, even in the case of a pure futures
  market widening of limits worsens the situation
  with margin (the margin will grow the following
  day). It can stimulate cross-defaults if the
  participants remain unwilling to apply additional
  margin.
• In the case of an options market widening of the
  the limits is possible but can be dangerous as
  mentioned above in the case of market stress.
• Narrowing of limits is always possible. It is a
  flexible instrument enabling to resolve numerous
  stalemate situations caused by low liquidity.

32
Limits

• Limits can be narrowed in different ways

• Uniform narrowing of the limits

• Different upper and bottom limits

• Nearing the maturity date

• Extreme case early execution

33
Dependence of margin on the level of limits

• Dependence of margin for 1 short options for 3
  futures (5 days to maturity) on the price limits
  (10, 15, 20, 25, 30 kop.)

34
Example of portfolio correction under the normal
market conditions

• The market is constituted by 3 agents, all
  holding spreads
• 1st day Everything is OK.
• 2d day One of the participant fails to meet the
  increased margin requirements. The portfolio
  passes under control of the exchange, the latter
  conducts corrective transactions
• 3d day Assignors portfolio requires further
  correction
• 4th day The portfolio is returned under
  assignors management

35
Up-front or futures-style?
36
Up-front or futures-style?

• Introduction of futures-style options compared to
  up-front options is similar to lending to the
  participants on the security of their portfolio
  (possibility of negative margin from up-front
  standpoint). This mechanism lowers required
  margin level.
• Besides, futures-style options are more natural,
  since for different portfolios with similar
  payoff functions the margin requirements are the
  same.
• However, from the participants viewpoint
  variation margin is rather frequently compensated
  by higher margin requirements.
• Conclusion margin requirements for futures-style
  options are not greater than those for up-front
  options.

37
Example. Up-front or futures-style?

• Blue line payoff function of the portfolio
• 2 short futures
• 1 long call
• Green line margin level in the case of up-front
  
• Red line difference between variation margin
  and margin requirements

38
Term of option

• It is possible to introduce
• 1-week options
• 1-month options
• In the case of 1-month options it is suggested
  that maturity dates for futures and options
  match.
• In the case of 1-week options maturity dates for
  both instruments are actually different.
• In the case of matching terms the amount of
  margin will not be less than that in the case of
  unmatching maturity dates.

39
American or European? With or without delivery?

• For a European option for futures with the
  maturity date matching with that of the futures
  there is no difference whether it provides for
  physical delivery or not.
• In the case of American option there is serious
  difference
• Margin level for a portfolio of American up-front
  options with physical delivery exceeds the margin
  level of European options portfolio.
• Margin level for American futures-style options
  is not higher than that of European options.
  However, in such system it is unreasonable to for
  a holder of such American options to execute it
  both from the viewpoint of margin improvement as
  well as the eventual profit.

40
Example. American options without physical
delivery
Green line current quoted price of futures
29.4 Dark blue line initial portfolio 1 short
call, 29 3 long futures Margin 2.2 Red line
portfolio after short calls execution by a
counterpart 3 long futures. It is necessary to
pay 1.2 Margin requirements 1.2 Shortage 0.2

• Introduction of American options without physical
  delivery leads to higher level of margin compared
  to European options.

41
Example. American up-front options with physical
delivery
Green line current quoted price of futures
29.1 Dark blue line initial portfolio 1 short
call 29 1 long call 29.3. Margin 0.9 Red line
portfolio after short calls execution 3 short
futures 29, 1 long call 29.3 Margin
requirements 1.5 Shortage 0.6

• Introduction of American up-front options with
  physical delivery leads to higher level of margin
  compared to European options.

42
Comparison of the variants
Type of options European American
With variation margin (futures-style) With the maturity dates of options and futures matching the type of settlement does not matter. Introduction of an option with physical delivery is optimal.
Without variation margin (up-front) Introduction of an option with physical delivery is optimal. Unreasonable margin level is significantly higher compared to the American futures-style options. Besides, the task in this case is much more complicated.
43
Liquidity loss scenarios
44
Liquidity loss scenarios

• Situations are possible on the market, when no
  trades with the underlying can be conducted at
  any of the prices within the current days price
  limits. We refer to such situations as loss of
  liquidity.
• The following scenarios of liquidity loss are
  possible
• Price shock of the underlying goes beyond the
  daily futures price limits. In this case
  immediate early execution of all contracts is
  recommended, with further re-launch of the market
  basing on the real price of the underlying (for
  futures) asset
• Stalemate situation all participants have
  balanced positions and enough margin. However,
  buying or selling futures results in higher
  margin for any of the participants.

45
Stalemate situation

• Stalemate situation is an absolutely new
  situation, impossible on a pure futures market.
• In the described system the situation of
  stalemate coupled with existence of an assignor
  may result in impossibility of corrective
  management.
• Formation of stalemate on a normally functioning
  market is hardly possible and first of all is a
  result of absence of speculators on the market.
• The system based on futures-style options is more
  stalemate-proof compared to up-front options.

46
Loss of liquidity situation of stalemate

• A market with 3 participants, of them one becomes
  an assignor (purple line)

47
Resolving of stalemate with the help of price
limits control

• One of the participants becomes an assignor, but
  the stalemate on the market makes the correction
  impossible. The exchange narrows the price limits
  for the whole period of maturity.

Green line current quoted price of futures.
Dark blue line payoff function of the
assignor's portfolio Red line margin level
under the previous limits (20 kopecks) Point
amount of funds Blue line margin level under
narrowed limits (12 kop.)
48
Resolving of stalemate with the help of maturity
shortening

• One of the participants becomes an assignor, but
  the stalemate on the market makes the correction
  impossible. The exchange shortens maturity of the
  instruments.

Green line current quoted price of futures.
Dark blue line payoff function of the
assignor's portfolio Red line margin level
under the previous limits (20 kopecks) Point
amount of funds Blue line margin level under
neared maturity date (4 to 1 day)
49
Comparison with the margin level. 1a
Portfolio payoff function
The portfolio consists of call options 2 long
options 3500 2 short options 3600 3 short
options 3700 4 long options 3800 1 short option
3900
50
Comparison with the margin level. 1b

• Black line Portfolio payoff function (here and
  below)
• Green line margin in RTS system with minus
  (here and below)
• Blue line guaranteed margin with minus, 2
  days to maturity
• Purple line guaranteed margin with minus, 10
  days to maturity

Limit 200, 3 days to maturity, volume of options
contract 5
51
Comparison with the margin level. 2

• Blue line guaranteed margin with minus, 1 day
  to maturity
• Purple line guaranteed margin with minus, 10
  days to maturity

The portfolio consists of put options 2 options
3500, -2 options 3600, 1 options 3700 Limit 200,
3 days to maturity, volume 5
52
Comparison with the margin level. 3

• Blue line guaranteed margin with minus, 10
  days to maturity
• Purple line guaranteed margin with minus, 20
  days to maturity
• Red line guaranteed margin, 40 days to
  maturity

The portfolio consists of call options 4 options
3500, -1 options 3600, -6 options 3700 2 options
3900 Limit 200, volume of options contract 5
53
Comparison with the margin level. 4

• Blue line guaranteed margin with minus, 3
  days to maturity
• Purple line guaranteed margin with minus, 5
  days to maturity
• Red line guaranteed margin, 20 days to
  maturity

The portfolio consists of call option with strike
3700 Limit 200, volume of options contract 5
54
Comparison with the margin level. 5

• Blue line guaranteed margin with minus, 5
  days to maturity
• Purple line guaranteed margin with minus, 10
  days to maturity
• Red line guaranteed margin, 20 days to
  maturity

The portfolio consists of options 1 put 3800,
-1 call 3500 Limit 200, volume of options
contract 5
55
SPAN Ideology

• The systems of SPAN type are built on the
  following assumptions
• The market is liquid there is always a
  possibility to liquidate the portfolio without
  considerable losses due to bid-ask spread.
• Liquidation value of the portfolio is determined
  by the current price and volatility according to
  a certain pricing model (for SPAN it is
  Black-Scholes).
• Margin level is defined as the worst liquidation
  value of the portfolio for some finite number of
  scenarios of daily changes in the price of
  underlying and the volatility
• Thus, SPAN takes into account only 1-day
  evolution of the market. The liquidation of the
  portfolio is implied in the case of margin
  deficit.

56
Corrective management

• Similarly to SPAN, the described system considers
  the worst variant of market development. However,
  at that all scenarios on the whole time horizon
  up to the execution are considered, which enables
  exchange to follow the most foresighted
  strategy in case of margin deficit.
• Different variants of realization of the
  described system are possible (including an
  unguaranteed system with lower margin
  requirements), all based on management of the
  futures part of the portfolio. For instance, an
  exchange can introduce a combined system in which
  the portfolio is liquidated if the corrective
  management does not succeed in a week.

57
Comparison of margin levels guaranteed system
vs. SPAN 1

• Black line payoff function
• Green line margin in SPAN
• Blue line guaranteed margin, limit 100
• Purple line guaranteed margin, limit 150

Portfolio 1 short call option Mean square
deviation of daily increment for a month 49,
once daily increments exceeded 100, 12 days to
maturity
58
Comparison of margin levels guaranteed system
vs. SPAN 2

• Black line payoff function
• Green line margin in SPAN
• Blue line guaranteed margin, limit 100
• Purple line guaranteed margin, limit 150

Portfolio -2 put 4700, 1 put 5100, 1 call
5500 Mean square deviation of daily increment for
a month 49, once daily increments exceeded 100,
8 days to maturity
59
Compliance with the requirements of regulator
(Report on margin, IOSCO, 1996)

• Margin levels should be designed to reduce
  credit, market and other risks.
• There can be various variants of the described
  system differentiating by the level of guarantees
  (which determine the level of margin) to the
  extent of a guaranteed system. All times the
  system is risk-based.
• Margin requirements may be used in combination
  with other mechanisms to minimize risk.
• The system is based on usage of daily price
  limits for the underlying. Besides it is
  conceived reasonable to use limits for open
  positions.

60
Compliance with the requirements of regulator
(Regulation of IOSCO of March 7, 1996)

• In calculated margin requirements, open positions
  should be revalued to current market prices at
  least once a day.
• The portfolio is revalued during the clearing
  session.
• Clear procedure for margin setting, collection
  and monitoring. Margin should be collected by
  clearly specified times.
• Within the described system the participants are
  obliged to meet the margin requirements only once
  at the beginning of the trading day (as a result
  of the last clearing session). Additional calling
  of margin in the course of trading day is not
  permitted.

61
Compliance with the requirements of regulator
(Regulation of IOSCO of March 7, 1996)

• In case of customer default, members should
  ensure that they are able to cover the positions
  of a defaulted customer. Provisions regarding
  customer defaults may include the liquidation of
  the customer's assets and closing of the account.
  
• In case of customer default a special procedure
  is provided for the portfolio temporarily passes
  under control of the exchange that, in turn,
  carries out a corrective strategy completely
  defined and specified by internal rules.

62
Compliance with the requirements of regulator
(Regulation of IOSCO of March 7, 1996)

• It may be useful to have special provisions for
  unusual or extreme market conditions.
• The described system provides for special rules
  for the case of loss of liquidity on the futures
  market.
• Market integrity is promoted in many
  jurisdictions through risk controls, including
  margin requirements.
• The procedure of reconciliation of margin
  deficit, including minimizing of the impact of
  corrective management on the market in the case
  of default, and the special rules for the case of
  loss of liquidity, are called to ensure systemic
  integrity of the market.