What Is Cross Margining?
Cross margining is the process of offsetting positions whereby excess margin from a trader's margin account is transferred to another one of their margin accounts to satisfy maintenance margin requirements. It is allowing the trader to use their available margin balance across all of their accounts.
- Cross margining is an offsetting process whereby excess margin in a trader's margin account is moved to another one of their margin accounts to satisfy maintenance margin requirements.
- The process allows a company or individual to use all of their available margin across all of their accounts.
- Cross margining increases a firm's or individual's liquidity and financing flexibility by reducing margin requirements and lowering net settlements.
- The unnecessary liquidation of positions and therefore potential losses is also avoided through cross margining.
- Cross margining services are calculated through clearing houses and clearing members, including prime brokerages that offer cross margining services to their clients.
- As a strong risk management tool, cross margining is particularly useful in volatile markets and for long-term trading strategies.
Understanding Cross Margining
Introduced in the late 1980s when the rise of financial instruments met increased market volatility, the use of cross margining increases a firm's liquidity and financing flexibility through reduced margin requirements and lower net settlements. It also prevents unnecessary liquidation of positions and therefore potential losses.
Before the establishment of cross margining, a market participant could encounter liquidity issues if it had a margin call from one clearing house that could not offset a position held at another clearing house. The cross margining system links margin accounts for member firms so that margin can be transferred from accounts that have an excess of margin to accounts that require margin.
At the end of each trading day, the clearing houses send settlement activity to organizations such as the Intercontinental Exchange (ICE) and the Options Clearing Corporation (OCC), 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 clearing houses on behalf of their clients.
Example of Cross Margining
If a client has multiple trading accounts that are margin accounts, it is better to margin them via cross margining as opposed to isolated margining. The primary reason is that it is a good risk management tool that prevents an unnecessary liquidation of positions.
For example, if a trader has $5,000 in account A with a margin requirement of $2,000, and $3,000 in account B with a margin requirement of $4,000, the client can easily satisfy the $1,000 shortfall in account B from the $3,000 excess in account A if they had a cross margining account set up.
If the trader could not cross margin their accounts and did not have any available capital at the moment to meet the shortfall in account B or was not able to take out the excess in account A due to a minimum account balance of $5,000, then they would have to liquidate positions in account B to reduce the margin requirement. If the trader's positions at that moment were at a loss, then they would incur an unnecessary trading loss by having to close out positions before a profit could be realized.
The benefit of a cross margined account is particularly useful in volatile markets that are witnessing extreme fluctuations whereby the predictability of margin requirements is difficult to gauge. This is especially true for long-term strategies implemented by traders and investment funds.
The primary motivation for cross margining is the risk management of a portfolio of sophisticated or complex financial instruments. Cost savings from a 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.