Funding Variation and Initial Margin

Finding the cash to pay margin is a funding problem for banks and funds.

What liquidity and funding risk is

Funding liquidity risk is the risk that a financial institution or other firm cannot meet expected or unexpected payments, or deliver the collateral it is asked for, without harming its daily operations or financial condition. It is distinguished from market liquidity risk, the risk that a firm cannot easily sell or offset a position at the market price because the market lacks depth or is not working normally¹. The funding burden of margin is a source of funding liquidity risk.

Even a derivative that exchanges no principal can drain cash as its value moves. The Basel Committee on Banking Supervision's principles ask banks, when they analyze liquidity risk, to include the payments that come from revaluing, exercising, and maturing derivatives. Banks also need to consider that counterparties may demand additional collateral. This can happen if the bank's own rating or creditworthiness falls, or if the price of the underlying asset falls².

The steps from receiving a demand for margin (a margin call) to paying it, and how disputes over the amount are resolved, are covered in Handling Margin Calls.

Variation margin and cash needs

When a bank hedges an uncollateralized client trade with a collateralized trade, it must raise cash equal to the variation margin it pays whenever the hedge loses value. Variation margin is margin exchanged to cover changes in the market value of trades. Japan Securities Clearing Corporation (JSCC) revalues the interest rate swaps and other trades it clears at least once a day and exchanges variation margin with its clearing participants³.

As of a 2018 paper, trades between financial institutions and trades through central counterparties were moving to collateralized terms. In Japan, however, uncollateralized trades were expected to remain, mainly with nonfinancial companies⁴. A typical case that creates funding costs is a financial institution that enters into an uncollateralized derivative with a nonfinancial company or similar client and then enters into an identical offsetting trade, with collateral, with a central counterparty or another financial institution⁵.

Consider a hypothetical example in which D is a nonfinancial company and S Bank is the hedge counterparty of R Bank. To fix the rate on its floating-rate loan, D enters into an uncollateralized interest rate swap with R Bank, paying a fixed rate and receiving a floating rate. To offset the gains and losses from rate moves on this trade, R Bank hedges with an opposite interest rate swap with S Bank. R Bank and S Bank have a credit support annex (CSA) and exchange variation margin every day. Under this CSA, both the threshold and the minimum transfer amount are zero, so the full change in value is covered with collateral.

Figure description

The interest rate swaps between D, R Bank, and S Bank, and the variation margin exchanged when rates fall. D pays a fixed rate to R Bank and receives a floating rate from R Bank. R Bank pays a fixed rate to S Bank, with which it exchanges collateral under a CSA, and receives a floating rate from S Bank. When rates fall and the trade with S Bank has a value of −300 million yen to R Bank, R Bank pays 300 million yen of variation margin (VM in the figure) to S Bank, while no collateral moves between D and R Bank. R Bank must fund the 300 million yen it pays to S Bank on its own.

When rates fall, the trade with D, on which R Bank receives the fixed rate, gains value from R Bank's point of view. The trade with S Bank, on which R Bank pays the fixed rate, loses value. R Bank pays S Bank the loss on the S Bank trade as variation margin. The gain on the D trade does not turn into cash, because R Bank receives no collateral from D. R Bank must therefore raise the cash it paid to S Bank on its own.

When rates rise, the direction reverses and R Bank receives variation margin from S Bank. As of a 2017 paper, standard collateral agreements between financial institutions allowed the receiver to reuse variation margin⁶. In that case, R Bank can use the cash it receives for its own funding.

The amount R Bank must raise for variation margin can be written as the formula below. If the hedge is the exact opposite of the D trade, and the threshold and minimum transfer amount in the CSA with S Bank are zero, the balance of variation margin paid to S Bank equals the gain on the D trade. Any collateral R Bank receives from D reduces the amount it must raise.

$$F = \max(V - X,\ 0)$$

$F$ is the cash R Bank raises for variation margin, $V$ is the value of the D trade from R Bank's point of view, and $X$ is the collateral R Bank holds from D. If the D trade is uncollateralized, $X$ is 0. The valuation adjustment that reflects the cost of raising this $F$ in the trade's value is FVA⁷. FVA is covered in Overview of XVA.

Worked example: three days of rate moves

Consider a hypothetical example in which R Bank has a 10 billion yen notional interest rate swap with D and hedges it with an opposite trade with S Bank. From R Bank's point of view, the two trades always have values of the same size and opposite sign. Variation margin covers each day's change in value, and the threshold and minimum transfer amount in the CSA with S Bank are zero, as in the previous section.

R Bank pays S Bank 100 million yen on day 1 and another 200 million yen on day 2. At the end of day 2, the balance of variation margin paid to S Bank is 300 million yen, the same as the 300 million yen value of the D trade. Applying the formula gives $F = \max(300 - 0,\ 0) = 300$, so R Bank raises 300 million yen.

When rates rise on day 3, the value of the S Bank trade goes from −300 million yen to 200 million yen, up 500 million yen, and R Bank receives 500 million yen from S Bank. R Bank gets back the 300 million yen it had paid and receives another 200 million yen. With $F = \max(-200 - 0,\ 0) = 0$, R Bank no longer needs to raise cash and can use the 200 million yen it received for its funding.

Funding initial margin

Initial margin received cannot be reused, so a firm must fund the full amount of the initial margin it posts from its own cash or other assets it holds. Initial margin is posted in advance to cover losses that could arise from value changes between a counterparty's default and the close-out of its trades.

In Japan, the Cabinet Office Order on Financial Instruments Business, etc. sets out the measures that financial instruments business operators and others must take for initial margin on OTC derivatives that are not centrally cleared. Initial margin received must be held in trust or by a similar method, so that it is available right away if the poster fails to perform and is returned to the poster if the receiver fails. The receiver also cannot pledge or lend it, with an exception only for safe handling that is incidental to managing initial margin received in cash⁸. Unlike variation margin, therefore, a firm cannot earn a return by investing the initial margin it receives⁹.

Consider a hypothetical example in which R Bank and S Bank must each post 400 million yen of initial margin to the other. R Bank receives 400 million yen from S Bank but cannot use it, so it must find the 400 million yen it posts to S Bank separately. On day 2 of the worked example in the previous section, R Bank would raise 700 million yen: the 300 million yen of $F$ plus the 400 million yen of initial margin.

The cost of funding initial margin is also reflected in the trade's value through a valuation adjustment, called MVA⁵.

Types of collateral and haircuts

Non-cash collateral is valued below its market value, and some margin can be paid only in cash, so a firm can run short of cash even while it holds bonds. Under Japan's margin rules, variation margin and initial margin are posted in cash or in assets specified by the Commissioner of the Financial Services Agency. The value of a non-cash asset is its market value minus the market value multiplied by a percentage set by the Commissioner. If the asset's currency differs from the currency the parties agreed on, a further percentage is deducted¹⁰.

The percentage deducted from market value when valuing collateral in this way is called a haircut. In a CSA, the parties set haircuts in advance for each type of collateral, taking into account how much its price moves¹¹. Consider a hypothetical example in which a government bond with a market value of 10 billion yen is posted with a 2% haircut. It counts as 9.8 billion yen of collateral. Around 2017, after even highly rated bonds fell sharply in price during the financial crisis, cash collateral, whose value does not move, was becoming more common, mainly in Europe and the United States¹¹.

At a central counterparty, the assets you can use depend on the type of margin. For JSCC's interest rate swaps, variation margin must be paid in Japanese yen cash, while initial margin can be posted in cash or as substitute securities in the form of Japanese government bonds or US Treasury securities. Initial margin posted in cash can be applied to variation margin payments, and variation margin to be received can be applied to initial margin payments¹²¹³. JSCC can change the collateral value of substitute securities (the substitute price) on a temporary basis, for example when market prices move sharply¹⁴. If the substitute price is cut, the same bonds count as less collateral.

According to views that the Financial Stability Board (FSB) heard from market participants, the problem was not holding liquid assets as such, but that turning them into cash to meet margin calls could become difficult when markets are under stress. For this reason, firms also need to hold cash rather than other high-quality assets, because repo markets, where firms borrow cash against bonds and other collateral, can freeze under stress¹⁵.

Examples of sudden increases in funding needs under stress

When markets move suddenly, variation margin payments and increases in initial margin rise at the same time, and cash needs swell over a short period. In March 2020, variation margin calls rose sharply from February in both centrally cleared and non-centrally cleared markets. Variation margin calls at central counterparties peaked at USD 140 billion on March 9, 2020. Initial margin on centrally cleared trades rose by about USD 300 billion during March, while initial margin on non-centrally cleared trades stayed relatively stable¹⁶.

Most market participants met their calls, but the impact varied with the size of their positions and how well prepared they were for liquidity needs¹⁷.

In the UK in late September 2022, a fiscal plan announcement triggered a sharp rise in long-term interest rates, and funds that managed money for corporate pension plans and used leverage faced large demands for additional margin¹⁸.

On the funding side, the turmoil stemmed from a temporary cash shortage caused by leveraged trades, not from a capital problem such as investment losses at pension plans or weaker finances. The additional margin the funds were asked for exceeded the cash that the pension plans had set aside, so the funds sold some assets to raise cash¹⁸. Pooled funds, which invest money from several pension plans together, could not quickly get more money from the plans and had no choice but to sell bonds¹⁹. One weakness behind the leverage that built up before the turmoil was that margin and collateral requirements were too low. An example is near-zero haircuts on bilateral UK gilt repos. Because repo haircuts were much lower than the initial margin that central counterparties charged on interest rate swaps, LDI funds were able to increase their leverage²⁰.

Margin plays an important role in containing counterparty credit risk, but it can also raise the liquidity risk of leveraged participants²¹.

Preparing in practice

A firm that pays margin sets aside cash not only for normal payments but also for the larger amounts it estimates it would owe when markets are under stress. In the example of D, R Bank, and S Bank, the cash R Bank sets aside is the sum of $F$ for variation margin and the initial margin it posts. Banks that use derivatives need to be able to check whether they hold enough unencumbered assets of the right type and quality. Their information systems should support this check²².

In December 2024, the FSB issued recommendations for non-bank market participants on preparing for margin calls. They include estimating how much initial margin and haircuts would rise under stress, and, for calls that can be met only in cash, holding cash in the currency of the call or reliable ways to raise it²³.

Notes

1. Basel Committee on Banking Supervision, "健全な流動性リスク管理及びその監督のための諸原則" (Principles for Sound Liquidity Risk Management and Supervision; provisional Japanese translation by the Financial Services Agency) (September 2008), footnote 2 (page 1) (in Japanese). The English original was published by the Basel Committee in September 2008; the page numbers above are those of the translation. ↩

2. The same principles, paragraph 40 (page 19) (in Japanese; page numbers are those of the translation). ↩

3. Japan Securities Clearing Corporation, "リスク管理 証拠金" (Risk management: margin, in Japanese; shown as of December 18, 2024), the opening explanation. An English version is available: "Margin". ↩

4. Takashi Kawakami, "ヘッジ取引におけるデリバティブ信用評価調整の影響についての考察" (A study of the effects of credit valuation adjustments of derivatives on hedging transactions), Kinyu Kenkyu, Institute for Monetary and Economic Studies, Bank of Japan (April 2018), footnote 15, page 130 (in Japanese). ↩

5. The same paper, Section 2 (1), pages 123–124 (in Japanese). ↩ ↩²

6. Yuichi Saito, "金融規制の複合的影響を考慮したXVA" (XVA taking into account the combined effects of financial regulations), Kinyu Kenkyu, Institute for Monetary and Economic Studies, Bank of Japan (April 2017), Section 1, page 110 (in Japanese). ↩

7. Yuichi Saito, "金融規制の複合的影響を考慮したXVA" (XVA taking into account the combined effects of financial regulations), Kinyu Kenkyu, Institute for Monetary and Economic Studies, Bank of Japan (April 2017), equation (2), pages 115–116 (in Japanese). In the paper, $X$ is the amount of collateral, positive for collateral the firm has received and negative for collateral it has posted. ↩

8. "金融商品取引業等に関する内閣府令" (Cabinet Office Order on Financial Instruments Business, etc., in Japanese), Article 123, paragraph 1, item 21-11 (d) and (e). ↩

9. Yuichi Saito, "金融規制の複合的影響を考慮したXVA" (XVA taking into account the combined effects of financial regulations), Kinyu Kenkyu, Institute for Monetary and Economic Studies, Bank of Japan (April 2017), Section 4 (1), page 121 (in Japanese). ↩

10. "金融商品取引業等に関する内閣府令" (Cabinet Office Order on Financial Instruments Business, etc., in Japanese), Article 123, paragraphs 10 and 11. ↩

11. Yuichi Saito, "金融規制の複合的影響を考慮したXVA" (XVA taking into account the combined effects of financial regulations), Kinyu Kenkyu, Institute for Monetary and Economic Studies, Bank of Japan (April 2017), "ニ. 適格担保" (d. Eligible collateral) in Section 3 (1) and footnote 9, page 118 (in Japanese). ↩ ↩²

12. Japan Securities Clearing Corporation, "リスク管理 証拠金" (Risk management: margin, in Japanese; shown as of December 18, 2024), notes 1 and 3 for interest rate swaps in "各清算業務における証拠金算出スケジュール" (Margin calculation schedule for each clearing business). An English version is available: "Margin". ↩

13. Japan Securities Clearing Corporation, "金利スワップ担保・決済" (Interest rate swap collateral and settlement, in Japanese), "当初証拠金、日中証拠金及び清算基金の差入れ及び返戻並びに変動証拠金の決済方法" (Methods for depositing and returning initial margin, intraday margin, and the clearing fund, and for settling variation margin). ↩

14. Japan Securities Clearing Corporation, "金利スワップ取引清算業務に関する業務方法書" (Business rules for the interest rate swap clearing business, in Japanese), Article 7, page 13. ↩

15. Financial Stability Board, "Liquidity Preparedness for Margin and Collateral Calls: Final report" (December 10, 2024), Section 1, the description of the FSB outreach meetings (page 6). ↩

16. Basel Committee on Banking Supervision, Committee on Payments and Market Infrastructures, and International Organization of Securities Commissions, "2020 年3 月の市場混乱期における証拠金の慣行についてのコメントを募集" (Consultation on margining practices during the March 2020 market turmoil; press release of October 26, 2021, provisional Japanese translation by the Financial Services Agency), page 1 (in Japanese). The English original is the press release issued by the three bodies on October 26, 2021. ↩

17. Financial Stability Board, "Liquidity Preparedness for Margin and Collateral Calls: Final report" (December 10, 2024), Section 1 (page 3). ↩

18. Bank of Japan Financial System and Bank Examination Department, "企業年金の運用戦略からみた金融安定への含意 ―英国債市場の混乱からの教訓―" (Bank of Japan Review 2023-J-2) (in Japanese), January 2023, "はじめに" (Introduction), the summary, and Chart 1 (page 1). English version: "Corporate Pension Funds' Investment Strategies and Financial Stability: Lessons from the Turmoil in the UK Gilt Market" (Bank of Japan Review 2023-E-3, March 2023). ↩ ↩²

19. Bank of Japan Financial System and Bank Examination Department, "企業年金の運用戦略からみた金融安定への含意 ―英国債市場の混乱からの教訓―" (Bank of Japan Review 2023-J-2) (in Japanese), January 2023, "金融安定への含意" (Implications for financial stability) (page 6). English version: "Corporate Pension Funds' Investment Strategies and Financial Stability: Lessons from the Turmoil in the UK Gilt Market" (Bank of Japan Review 2023-E-3, March 2023). ↩

20. Financial Stability Board, "Leverage in Nonbank Financial Intermediation: Final report" (July 9, 2025), Section 2.2, "September 2022, LDI crisis" (pages 7–8), and footnote 16 (page 9). ↩

21. Bank of Japan Financial System and Bank Examination Department, "企業年金の運用戦略からみた金融安定への含意 ―英国債市場の混乱からの教訓―" (Bank of Japan Review 2023-J-2) (in Japanese), January 2023, "レバレッジ取引に伴う流動性リスク" (Liquidity risk from leveraged transactions) in "金融安定への含意" (Implications for financial stability) (page 5). English version: "Corporate Pension Funds' Investment Strategies and Financial Stability: Lessons from the Turmoil in the UK Gilt Market" (Bank of Japan Review 2023-E-3, March 2023). ↩

22. Basel Committee on Banking Supervision, "健全な流動性リスク管理及びその監督のための諸原則" (Principles for Sound Liquidity Risk Management and Supervision; provisional Japanese translation by the Financial Services Agency) (September 2008), paragraph 93 (page 35) (in Japanese). The English original was published by the Basel Committee in September 2008; the page numbers above are those of the translation. ↩

23. Financial Stability Board, "Liquidity Preparedness for Margin and Collateral Calls: Final report" (December 10, 2024), Recommendation 5 (page 17) and Recommendation 7 (page 19). ↩