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Here is a hypothetical scenario: Bank A sells 1 SPX CALL/PUT to a retail trader who uses Bank B. The SPX becomes in the money. SPX is cash-settled. So Bank A transfers reserves held at Federal Reserve to Bank B to settle interbank liabilities.

Is that allowed?

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Yes.

Deposits with the Federal Reserve are assets owned by bank A. Typically they are rebalanced everyday. So:

Day 1: Bank A deposits $ 1bn with FED.
Day 2: Bank A receives back $1bn, pays $100mm to another CP and deposits $900mm with FED.

Providing the bank operates within official regulations what it does with its $1bn is its own business, i.e. one such regulation might be maintaining a specific minimum reserve requirement relating to its retail liabilities, (i.e retail deposits).

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There are two forms of liability with options. The margin and the actual final settlement. Every day the options are evaluated to see their value. As the options fluctuate in value one counterparty will need to post more collateral and the other side will receive the collateral. In the case of OTC options the collateral may go to a neutral 3rd party. In the case of listed you are going to deliver collateral to the OTC.

In all of the above cases you are not delivering reserves. You are delivering bonds, bills, maybe gold, certain stocks in the case of certain collateral agreements.

For final settlement, you get your collateral back and then use SWIFT to sent the actual money. In that case you are sending actual reserves. Then, as mentioned above, the reserves are entirely fungible.

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  • $\begingroup$ I agree that collateral to settle daily MTM is mostly non-cash, but certainly can be cash also... depends on the preference of the institution that needs to post it. They'd choose the cheapest-to-deliver collateral, and that may well be some cash, if on that specific day (for example) the treasury received a large deposit (or it could be many other reasons...). $\endgroup$ Feb 12, 2021 at 8:39
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    $\begingroup$ I've generally not seen cash being used. I know it qualifies, but people seem to always prefer bills. I think that it might have some added level of safety in case of default as you have a specific asset to reclaim. $\endgroup$
    – JoshK
    Feb 12, 2021 at 13:28
  • $\begingroup$ That's interesting. I am based in Europe, I am aware that in the US the bills market is abundant and very liquid. I don't think the European govies market is as deep as the US one (although it's also very liquid), perhaps that's why cash is sometimes used in Europe (at least I recall so). Always great to gather other perspectives here on this site! :) $\endgroup$ Feb 12, 2021 at 13:41
  • $\begingroup$ Actually I saw cash being used as gold standard in as many cases as possible, and this was at large trading houses - JP, GS, Barclays, MS. Funds typically preferred to post securities assets because that was most readily available for them, but a bit of a pain for the banks. $\endgroup$
    – Attack68
    Feb 21, 2021 at 7:44
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Perhaps worthy of distinction is that a bank swap dealer would be a bilateral counterparty for an OTC uncleared derivative, but most options trade through broker-dealers and are centrally cleared (OCC, not the Fed). Retail trades would not go through the bank; they would trade through a broker who has an account with the OCC and must maintain certain excess margin / collateral there for its book of accounts. The broker is responsible for ensuring its customers' trades settle; the individual trader is the responsibility of the broker. The OCC guarantees performance of the settlement between brokers. Again, this does not happen at the Fed, but at the OCC. No wiring takes place at settlement, instead, brokers are debited or credited for their balance.

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  • $\begingroup$ Yeah - and in almost all of those cases the collateral transfer is not actual cash. It's usually bills or similar. $\endgroup$
    – JoshK
    Feb 11, 2021 at 4:28
  • $\begingroup$ Right, the collateral can be a wide basket of assets that usually have valuation haircuts based on risk and liquidity $\endgroup$
    – Kch
    Feb 11, 2021 at 14:17
  • $\begingroup$ I heard that for UMR they will take .spx stocks - but I don't know if anyone uses it. I've heard that most collateral management groups can't handle processing equities. $\endgroup$
    – JoshK
    Feb 11, 2021 at 15:24
  • $\begingroup$ Typically equities are heavily haircut as collateral given their volatility. My professional experience is limited to rates on this, but swap dealers tend to box you in to posting fixed income assets $\endgroup$
    – Kch
    Feb 11, 2021 at 22:23
  • $\begingroup$ Yeah, I tried to get equity collateral to be accepted a few years ago but found that every collateral manager wasn't equiped. $\endgroup$
    – JoshK
    Feb 12, 2021 at 4:10

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