Initial Margin vs. Variation Margin in OTC Trades
Initial Margin vs. Variation Margin in OTC Trades
Initial margin (IM) and variation margin (VM) serve different purposes in managing counterparty credit risk. Variation margin covers current mark-to-market exposure, while initial margin provides a buffer against potential future exposure during the close-out period. Understanding both is essential for OTC derivatives operations.
Definition and Key Concepts
Fundamental Difference
| Aspect | Variation Margin | Initial Margin |
|---|---|---|
| Purpose | Cover current MTM | Buffer for close-out period |
| Calculation basis | Net exposure today | Potential future exposure |
| Direction | Two-way (either party posts) | Two-way (each party posts) |
| Frequency | Daily (or more) | Recalculated periodically |
| Segregation | Not required | Required at third-party custodian |
| Rehypothecation | Typically allowed | Prohibited |
Regulatory Framework
Key regulations requiring margin:
| Jurisdiction | Regulation | Effective Dates |
|---|---|---|
| United States | CFTC/Prudential Rules | VM: March 2017; IM: phased 2016-2022 |
| European Union | EMIR RTS | VM: March 2017; IM: phased 2017-2022 |
| United Kingdom | UK EMIR | Aligned with EU (post-Brexit) |
| Japan | JFSA Rules | Aligned with global timeline |
| Global | BCBS-IOSCO | Framework underlying all rules |
Covered Entities
IM requirements apply to:
- Banks and broker-dealers
- Swap dealers and major swap participants
- Entities exceeding notional thresholds
IM threshold (US): $8 billion average aggregate notional amount (AANA) of non-cleared derivatives
How It Works in Practice
Variation Margin Mechanics
Daily VM calculation: VM Required = max(0, MTM - Threshold - MTA)
Example:
- Net MTM: Party A owes Party B $5 million
- Threshold: $0 (regulatory requirement)
- MTA: $500,000
- VM call to Party A: $5 million
Key operational points:
- Calculated daily based on current portfolio MTM
- Netted across all transactions under CSA
- Cash typically required (no haircut)
- Transfer deadline typically same or next business day
Initial Margin Mechanics
IM purpose: Cover potential losses during the close-out period (typically 10 business days for non-cleared swaps).
Calculation methods:
| Method | Description | Use Case |
|---|---|---|
| ISDA SIMM | Risk-based sensitivities model | Industry standard |
| Standard Schedule | Notional-based percentages | Fallback or simple portfolios |
| Internal Model | Firm-specific VaR-based | Regulatory approval required |
ISDA SIMM calculation: IM = f(Delta, Vega, Curvature, Concentration) with correlation offsets
SIMM Example
Portfolio sensitivities:
- Interest rate delta: $2 million DV01
- Credit spread delta: $500,000 CS01
- FX delta: $1 million
SIMM calculation (simplified):
- IR delta contribution: $2,000,000 × risk weight
- Credit contribution: $500,000 × risk weight
- FX contribution: $1,000,000 × risk weight
- Correlation adjustments: (reduce total)
- Total IM: ~$25 million per party
Key points:
- Each party calculates and posts IM to the other
- Gross IM (no netting between parties)
- Segregated at third-party custodian
Worked Example
Trade details:
- 5-year interest rate swap
- Notional: $100 million
- Party A pays fixed 4.50%
- Party B pays SOFR
Day 1: Trade inception
- MTM: $0 (par swap)
- VM required: $0
- IM required (SIMM): $2.5 million per party
Day 30: Rates rise 25 bps
- New MTM: Party A gains $1.1 million
- VM: Party B posts $1.1 million to Party A
- IM: Recalculated (may increase slightly due to higher rates)
Day 60: Rates fall 50 bps from inception
- New MTM: Party A loses $2.3 million
- VM: Party A posts $2.3 million to Party B
- IM: Remains approximately $2.5 million per party
Collateral summary (Day 60):
| Margin Type | Party A Posts | Party B Posts |
|---|---|---|
| Variation Margin | $2,300,000 | $0 |
| Initial Margin | $2,500,000 | $2,500,000 |
| Total | $4,800,000 | $2,500,000 |
Standard Schedule Alternative
If using Standard Schedule instead of SIMM:
| Asset Class | IM Rate | Notional | IM Amount |
|---|---|---|---|
| Interest Rate (5Y) | 2% | $100M | $2,000,000 |
Standard Schedule often produces higher IM than SIMM for diversified portfolios but lower for concentrated positions.
Risks, Limitations, and Tradeoffs
Operational Complexity
| Challenge | VM | IM |
|---|---|---|
| Calculation frequency | Daily | Daily or periodic recalc |
| Dispute risk | Moderate (MTM-based) | Higher (model-based) |
| Settlement timing | Same-day or T+1 | T+1 or T+2 |
| Custody | Standard | Third-party segregation |
| Documentation | VM CSA | IM CSA + custody agreement |
Liquidity Impact
IM creates ongoing funding need:
| Portfolio Size | Estimated IM (each party) |
|---|---|
| $1 billion notional | $20-40 million |
| $10 billion notional | $150-300 million |
| $100 billion notional | $1-2 billion |
These amounts must be held as high-quality liquid assets.
Wrong-Way Risk
IM collateral can decline in value when counterparty defaults:
| Scenario | Risk |
|---|---|
| Credit crisis | Government bonds may appreciate (flight to quality) |
| Rate spike | Long-duration bonds lose value |
| Market stress | Eligible collateral becomes illiquid |
Dispute Scenarios
Common IM disputes:
| Issue | Cause | Resolution |
|---|---|---|
| Sensitivity mismatch | Different models/inputs | Exchange sensitivities; reconcile |
| Trade population | Missing or extra trades | Reconcile portfolios |
| SIMM version | Different SIMM versions | Agree on version |
| FX conversion | Different rate sources | Specify rate source in CSA |
Common Pitfalls
| Pitfall | Description | Prevention |
|---|---|---|
| Threshold confusion | IM has no threshold (regulatory) | Understand regulatory minimums |
| Segregation failure | IM not properly segregated | Verify custody arrangements |
| Recalculation lag | IM not updated after new trades | Implement real-time SIMM |
| Eligible collateral mismatch | Posted collateral not eligible | Maintain collateral eligibility list |
Regulatory Comparison
US vs. EU IM requirements:
| Feature | US (CFTC/PR) | EU (EMIR) |
|---|---|---|
| AANA threshold | $8 billion | €8 billion |
| Calculation method | SIMM or Schedule | SIMM or Schedule |
| Margin period of risk | 10 business days | 10 business days |
| Minimum IM threshold | $50 million | €50 million |
| Segregation | Required | Required |
| Cross-border | Substituted compliance | Equivalence decisions |
IM threshold application: If calculated IM between two parties is less than $50 million, no exchange required. Above $50 million, full amount must be exchanged.
Checklist and Next Steps
VM implementation checklist:
- Execute VM-compliant CSA with each counterparty
- Establish daily valuation process
- Define eligible collateral (cash required by regulation)
- Set up margin call workflow
- Implement dispute resolution procedures
- Configure settlement processes
IM implementation checklist:
- Execute IM CSA (2018 IM Credit Support Deed or similar)
- Establish third-party custody arrangements
- Implement SIMM calculation capability
- Set up sensitivity reporting to counterparties
- Create IM dispute resolution process
- Monitor AANA threshold annually
- Document regulatory classification
Related articles:
- For collateral terms, see Credit Support Annex and Collateral Terms
- For trade execution, see Swap Execution Facilities (SEFs)