0
$\begingroup$

In Section 2.5 of Options, Futures, and Other Derivatives (8th edition), there is a paragraph discussing the credit risk associated with the operation of margins:

The whole purpose of the margining system is to ensure that funds are available to pay traders when they make a profit. Overall the system has been very successful. Traders entering into contracts at major exchanges have always had their contracts honored. Futures markets were tested on October 19, 1987, when the S&P 500 index declined by over 20% and traders with long positions in S&P 500 futures found they had negative margin balances. Traders who did not meet margin calls were closed out but still owed their brokers money. Some did not pay and as a result some brokers went bankrupt because, without their clients’ money, they were unable to meet margin calls on contracts they entered into on behalf of their clients. However, the clearing houses had sufficient funds to ensure that everyone who had a short futures position on the S&P 500 got paid off.

The author did not elaborate the reason of "the clearing houses had sufficient funds to ensure that everyone who had a short futures position on the S&P 500 got paid off", under the circumstance that many long positions were not able to meet margin calls. Given that, where did the "sufficient funds" come from? More generally, is the margining system still able to mitigate a party's credit risk when its counterparty's margin balances are negative? If so, how?

$\endgroup$
3
  • $\begingroup$ @nbbo2 Thank you for the responses. It makes sense. To clarify, the Clearing House used its own reserve and the capital collected from other performing brokers to pay the traders had short positions. Am I understanding correctly? $\endgroup$
    – Zhanxiong
    Dec 2, 2022 at 13:36
  • $\begingroup$ Yes I think we are in agreement. $\endgroup$
    – nbbo2
    Dec 2, 2022 at 18:37
  • $\begingroup$ @nbbo2 Thanks again for your confirmation. If you want to transcribe the comments to an answer, I will be happy to upvote and accept it. $\endgroup$
    – Zhanxiong
    Dec 2, 2022 at 19:04

1 Answer 1

1
$\begingroup$

The margin system for futures is a two level system. Each Broker has some capital (required in order to stay in business) and the Clearing House has some reserves as well. The Oct87 event that Hull describes wiped out the capital of some brokers (the shareholders lost all their money when some customer(s) could not pay their losses) but the Clearing House was able to make the required payments. The system worked.

Keep in mind that when the customer can't pay his losses it is the broker that is responsible for paying. This is why brokers are (or should be) careful to check a new customer's ability to pay before opening a new account. Opening a futures account involves a credit decision. In a serious loss situation where the margin the customer put up is depleted and the account balance goes negative the broker's survival is at stake as he is responsible for paying the Clearing House.

In the October 1987 situation, the Clearing House used its own reserve and the funds collected from performing brokers to pay the traders that had short positions.

$\endgroup$

Your Answer

By clicking “Post Your Answer”, you agree to our terms of service and acknowledge that you have read and understand our privacy policy and code of conduct.

Not the answer you're looking for? Browse other questions tagged or ask your own question.