Latin American Capital Markets

366 A. M. CORCORAN, R B. HOBSON, G.J. KUSERK, K. K. WUERTZ,AND QWESTbecause clearing members are required to settle at least daily in cash all losses onhouse and customer positions, thereby permitting the clearing organization to distributedaily gains in cash on all house and customer positions so that, in theory, thevalue of each futures contract is reset at zero on a daily basis. Standing margin is intendedto cover the credit risk to the clearing organization that its clearing memberswill not make daily settlement, that is, pay variation margin. 44Standing margin is set based on an assumption that any position could be liquidatedor the credit risk offset within that one-day window.Therefore, market risk ispriced daily, and credit risk is effectively removed from the system on a daily (or morefrequent) basis. Daily variation settlement is intended to ensure that gains are notpermitted to accumulate against a counterparty whose capacity to pay may changeover time based on market events, a change in its business fortunes, or because of itsother exposures. Measuring the risk that is thus removed from the system (which estimatesthe replacement cost of the contract) is a straightforward process becausesuch risk is valued based on actual prices, and reduction of this risk is a concern ofmarket participants and operators as well as regulatory authorities. The more liquidthe market, the more controlled this risk is.Most futures regulation requires profits and losses to be settled daily or morefrequently because credit is not evaluated on a transaction-by-transaction basis. Thepayment of daily variation is intended to avoid situations where accrued losses gounnoticed or losses exceed financial capacity and posted collateral.The cash flow tosupport variation payments also can be provided by drawing on lines of credit andother guarantees. Regulators and policymakers should require markets and commoncounterparties to have adequate procedures for addressing market risk and relatedand unrelated credit risk, including adequate funding liquidity arrangements. Regulatorsalso should be concerned that market users not insulate themselves from responsibilityfor their proprietary trading by the use of limited risk vehicles. If guaranteesor automatic deductions are used, as in the case of some electronic markets,pre-prescribed credit limits or automatic filters also may be desirable.Some markets use automatic trading halts when prices hit a specified limit topermit collection of margin purportedly to protect the conclusion of settlement andfinancial integrity. However, economists believe these types of price limits may interferewith the hedging efficacy of the markets because cash market prices are not sim-44 Standing margin is a deposit in the nature of collateral. It collateratizes the obligation to pay variation margin. It couldthus be regarded as a measure of the likely replacement cost to liquidate or repurchase the position. Standing marginis generally posted in highly liquid securities or cash equivalents. Variation margin is the payment of daily profitsand collection of losses that must be paid in cash.Copyright © by the Inter-American Development Bank. All rights reserved.For more information visit our website: www.iadb.org/pub