What is Cross Margining
Cross margining is the process of offsetting positions whereby excess margin from one account is transferred to another account to satisfy margin maintenance requirements. Introduced in the late 1980s when the rise financial instruments met increased market volatility, cross margining increases firms' liquidity and financing flexibility through reduced initial margin requirements and lower net settlements.
BREAKING DOWN Cross Margining
Before the establishment of cross margining, a market participant could encounter liquidity issues if it had a margin call from one clearinghouse that could not offset a position held at another clearinghouse. The cross margining system links margin accounts for member firms so that margin can be transferred from accounts that have excess margin to accounts that require margin. At the end of each trading day, the clearinghouses send settlement activity to organizations such as Intercontinental Exchange (ICE) and the Options Clearing Corporation, which then perform the calculations for clearing level margins and produce settlement reports to clearing members. Prime brokerages also provide cross margining services by interfacing with the clearinghouses on behalf of their clients.
Cross Margining Caveats
The primary motivation for cross margining is risk management of a portfolio of sophisticated or complex financial instruments. Cost savings from more efficient placement of margin is secondary. Benefits of cross margining are clear to institutional investors, but they must make sure that appropriate correlations of the assets in their portfolio, whatever the trading strategy, are modeled and monitored so that they are not imperiled in an extreme trading environment. Moreover, even though margin can be transferred friction-free among accounts to meet minimum requirements, it is also important that traders do not keep margin balances (above the requirements) too low, as this could limit flexibility in times of market volatility.