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 exchange’s 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 system’s construction.

7. What determines margin level requirements • In any system the margin level depends on the method of corrective management of assignor’s 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 assignor’s option positions margin is defined as a minimal amount required to cover all losses under the given portfolio in case of the participant’s 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 participant’s 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 assignor’s 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 exchange’s impact on the market: initial period ofcontrol • 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 contractor’s 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. Three open call options on the market with strikes 28.7, 28.9, 29.1 Current futures price – 28.95 (Green line) 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 (Blueline, the margin is 0) 3. 1 short call 28.7 1 long call 29.1 (Purple 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 system’s 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 – 1futures in the contract Redline – 3 Blueline – 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 portfolio’s 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 marketconditions 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 – Assignor’s portfolio requires further correction • 4th day – The portfolio is returned under assignor’s management

35. Up-front orfutures-style?

36. Up-front orfutures-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 participant’s 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 shortcall, 29; 3 long futures Margin 2.2 Red line – portfolio after shortcall’s 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 shortcall 29; 1 longcall 29.3. Margin– 0.9 Red line – portfolio after shortcall’s execution: 3 short futures 29, 1 longcall 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

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 day’s 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