Variation margin

A clearing house does not wait until maturity to find out whether a counterparty can pay. It revalues every position at the end of each day and moves cash between the parties so that nobody ever owes very much. That daily payment is variation margin. It is separate from initial margin, which is a deposit posted at the outset as a buffer against the move that happens between the last settlement and a default.

For a company hedging a real exposure, variation margin creates a timing mismatch that has nothing to do with whether the hedge works. The derivative settles daily. The physical exposure it offsets settles when the goods are bought or the invoice is paid, which may be spread across a year. So a hedge that is on course to offset the exposure exactly can require cash out for months before the benefit arrives.

This is the single strongest practical argument for hedging with bilateral forwards where a bank will write them, because a forward settles once and the cash timing follows the exposure. It is also why the credit and liquidity arrangements behind a hedging programme are part of the design rather than an administrative detail: a company that cannot fund margin has to close a hedge at the worst possible moment, which converts a timing problem into a real loss.

European collateral rules have been extending margining beyond exchange traded contracts to categories of over the counter derivative, with different treatment for non financial companies below certain thresholds. The scope has been revised repeatedly, so treat the direction of travel as the point rather than any specific figure.