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Introduction

The following is a summary of WP2 members' margin survey responses. The survey covers margin requirements as they apply to equities and derivatives based on equities. Margin requirements also may apply to non-equity based products; however, they are beyond the scope of this survey. The responses reflect the important role that margin plays in contributing to the efficient operation and risk management of the secondary markets. Although there are differences in margin regulation among WP2 members, both with respect to the types of instruments and the types of investors to which it applies, there are a number of common features.

1. General

1.1 Margin on equities generally functions as a loan, and is similar to a down payment required for the purchase of a security. Margin on derivatives based on equities, on the other hand, represents a performance bond; margin on derivatives is intended to guarantee that a party to a derivatives transaction will perform its obligation under the derivative contract. In general, margin is intended to protect against the effects of default, and is generally based on valuation scenarios.

1.2 Market authorities generally require margin for many derivatives transactions, and often require margin for equity transactions. There are however significant conceptual differences between securities margin and derivatives margin. While most market authorities require margin, they differ in the scope of financial instruments to which margin requirements apply.(See chart in Survey Response 1.1)

1.3 In some countries banks may be allowed to extend credit to their customers on securities and derivatives trades without providing margin. In other countries, margin is required from banks as from other participants. In jurisdictions with a universal banking system (e.g., Germany, Switzerland), securities and derivatives trading is an integral part of banking business. In such jurisdictions, margin requirements apply equally to banks and non-banks for their derivatives transactions.

1.4 While these regulations (with respect to both equity and derivatives margin) often are required by statute, specific margin requirements are found in the rules of the regulators, exchanges, and clearinghouses. In most jurisdictions, broker-dealers, exchanges, and clearinghouses may require margin deposits in addition to those that are required by statute or rule.

1.5 Firms may provide margin to a clearinghouse either on a gross or a net margining basis. With gross margining, margin is calculated both on the net longs and the net shorts within a given account, without set off between long and short positions. With net margining, the longs and shorts on a given account are set off against each other, and margin is calculated on the net position.

1.6 With respect to the equity market, most market authorities require margin payments from customers as well as financial intermediaries, with some exceptions.

1.7 While some market authorities communicate among each other on a regular basis on margin matters, others communicate only under specific circumstances or during periods of extreme volatility. Communications may be formal or informal. For example, in France, clearinghouses and exchanges communicate on or around the expiration date of certain derivative instruments. In the United States and France, options and futures clearinghouses have entered into agreements for the exchange of information with respect to cross-margining transactions (See Section 6). Market regulators in the United States, Italy, and Japan are in continuous contact with their exchanges and clearinghouses by virtue of the regulatory relationship. In particular, in the United States, the Securities and Exchange Commission ("SEC") and Commodity Futures Trading Commission ("CFTC") have strongly supported exchanges and clearing agencies in the establishment of formal networks of communications. In Australia, exchanges only communicate in times of emergency.

1.8 Margin requirements involve a balancing of the perceived effects of margin in reducing various types of risk and the potential impact of margin on market participants and liquidity. There are two basic approaches to balancing these effects: one view is that margin is essential to the financial safety of markets and the potential cost of margin is outweighed by the benefit of reducing risk; the other view is that margin requirements (especially those required for derivatives transactions) have little, if any, impact on market liquidity, and the potential costs of margin should not curtail the activity of market professionals that are adequately capitalized. Solutions to limiting such potential effects may include cross-margining and the use of a wider range of types of collateral.

2. Risks

2.1 For both equity and derivatives trading, margin protects market participants from credit, market, and other risks. In particular, margin in the equity market is intended to address the credit and price risks associated with a loan that a broker-dealer or other financial intermediary has extended to its customers.

This is true also for universal banking systems. But there is no regulation of margin requirements with regard to such loans.

In the futures and options markets, margin is intended to protect participants from price movements in individual instruments and market volatility, such that the cost of liquidating certain positions would be covered by the margin up to a maximum worst-case scenario. By dealing with these risks, margin serves to minimize the risk arising from multiple defaults.

2.2 Market authorities in all WP2 member countries recognize that there is a high price correlation between derivatives and their underlying instruments. In addition, in some jurisdictions, market authorities also believe that there is a correlation between two derivative instruments and have accordingly allowed cross-margining based on that correlation.

2.3 In addition to the operational standards that apply in most markets, market integrity is promoted in many jurisdictions through risk controls, including margin requirements. Other risk controls used to respond to extreme market volatility and manage the risks mentioned above include circuit breakers (Canada, France, Italy, Japan, United States, Spain), position limits (France, Australia, Italy, United States, Germany), price limits (Japan, Mexico, Italy, Germany, Spain), trading halts (France, Mexico, Italy, United States, Germany, Spain), capital adequacy (Australia, United States, France, Mexico, Spain, United Kingdom), and to a certain extent scrip lending limitations (United Kingdom).

2.4 While other risk controls as above do not necessarily affect margin requirements directly or specifically, many market authorities generally intend to minimize risks to the market by designing an appropriate combination of risk controls including margin requirements. Under the unique market conditions in each market, implications of the other risk controls to margin requirement generally are assessed with a view toward promoting financial safety of the markets.

2.5 With respect to customer default, in most jurisdictions only the broker-dealer has a direct relationship with the clearinghouse, and the broker-dealer must cover the positions of a defaulted customer in order to remain in good financial standing vis-a-vis the clearinghouse. Provisions regarding customer defaults sometimes are within the discretion of the broker-dealer, but generally require the liquidation of the customer's assets and closing of the account.

2.6 While differences exist among WP2 members, provisions for member default generally require either the transfer of customer positions, funds, or assets held by such member, or the liquidation of customers positions, funds, or assets. These provisions also generally require the liquidation of member firm positions, funds, and assets, transfer of accounts, use of available margin funds, and, if necessary, the use of other available funds at the clearinghouse. In most jurisdictions clearinghouses are responsible for obligations of the defaulting member to clearinghouse counterparties, and in some jurisdictions (e.q., France (MATIF SA) and Spain), to customers of the defaulting member.

3. Margin Levels

3.1 As mentioned earlier, margin levels are established either by statute or by the rules of regulators, exchanges and clearinghouses. In many cases, broker-dealers charge their customers higher margin than required by rule or statute. In most cases, the exchanges and clearinghouses have no direct contact with their members' customers, except in the United Kingdom where OMLX, an options and futures exchange under the jurisdiction of the SIB, may carry customer accounts directly, and in Spain where the clearinghouse knows and calculates margin levels for each customer, thereby creating a direct and special relationship between the clearinghouse and its members' customers.

3.2 Many market authorities require both initial and maintenance margin from both members (such as financial intermediaries) and non-members (such as customers of those financial intermediaries) of a clearinghouse for most instruments. Initial margin refers to margin paid at the initial stage of a transaction, and maintenance margin refers to margin required during the stages of a transaction. A common fundamental element in the establishment of margin levels in both the equity and derivatives markets is the importance of the historic volatility of price and market. However, market authorities differ substantially in the way they determine margin. Some calculate margin on a net basis; some calculate margin on a gross basis; and some differ in their calculation depending upon the types of instruments, the type of participants, and whether the margin is initial or maintenance.

3.3 Different types of instruments are subject to different margin requirements. In some jurisdictions, including Canada and the United States, market authorities take into account whether the client is a speculator or hedger, while such distinction is not made in other jurisdictions, including Japan and France. In all jurisdictions customers may be subject to higher margin levels, either pursuant to a rule or at the discretion of the broker-dealer. While clearinghouses in some jurisdictions do not distinguish among clearing members in setting margin requirements,¹ those in some other jurisdictions (such as Canada, Italy, the Netherlands, and the United States) distinguish among members based upon their creditworthiness and overall trading activity.

3.4 All jurisdictions reported that competition does not play any role in the determination of margin.

3.5 In many jurisdictions market authorities do not have regularly scheduled periods for margin reviews, in others market authorities reexamine margin periodically (daily, weekly, or monthly). Market authorities look at volatility as a key element in deciding whether to revise the margin requirements.

3.6 Market authorities differ greatly in the methods they use to calculate margin. Some use options pricing models while others do not. Equity options exchanges in a growing number of jurisdictions (such as the Netherlands, Australia, Quebec, Italy, and the United States (SEC)) use the Theoretical Intermarket Margin System ("TIMS") system of accounting. Financial futures and options exchanges in a number of jurisdictions (including Australia, Spain, France (in the near future), the United Kingdom, and the United States (CFTC)) use the Standard Portfolio Analysis of Risk ("SPAN") system. Finally, open positions in the derivatives markets are marked-to-market daily in all jurisdictions.

4. Margin Collection and Monitoring

4.1 Generally, clearinghouses calculate and collect margin from their members and the members collect margin from their customers. Oftentimes the exchanges and clearinghouses determine the methods and means used for calculating and collecting margin.

4.2 Margin collection and notification procedures vary widely: in a number of jurisdictions, margin on futures and options are calculated and collected daily or more frequently in some circumstances (by clearinghouses, exchanges, or broker-dealers); in Japan, they are collected as much as three days after calculation.

4.3 In most jurisdictions, financial intermediaries and their customers are margined separately, but under the same or similar methodology. In some jurisdictions, the margin level applied to financial intermediaries is different from that applied to their customer accounts.

4.4 Various types of collateral are permitted by the various market authorities. Relevant factors include the market and who is required to submit margin, e.g;, exchange member, clearinghouse member, or public customer. Types of collateral range from cash only, to including domestic, foreign or international currency and securities, equity and/or debt. The choice of collateral permitted is based on criteria such as high liquidity, reduced credit and market risks. Except in Australia and Mexico, where haircuts are not applied, in most other WP2 jurisdictions haircuts range from O to 50%. Haircuts aim at taking into account the risk of a possible reduction in the market value of these instruments at the time the clearinghouse might have to sell them in case of a member's default. (See Survey Response for additional information.)

5. Extraordinary Market Conditions

5.1 Except in the Netherlands and Mexico, market authorities in all other WP2 jurisdictions provide special regulations to respond to extreme market conditions. In most cases intra-day margin calls are made that must be satisfied relatively promptly (e.g.,one hour). Intra-day margin payments generally are made from customers to broker-dealers and from broker-dealers to clearinghouses. There are no refunds to members of clearinghouses or customers of broker-dealers in case there is excess margin in an account. In the United States, France, Canada, and Japan, special provisions for extreme market volatility have been activated on various occasions in order to control the risks arising from extreme volatility. For example, exchanges in Japan may change initial margin levels and change the haircuts of collateral.

5.2 The benefit of coordinating or consulting about such rules among relevant domestic market authorities is regarded as important in some jurisdictions to protect market participants from possible defaults. Furthermore, sharing information on structural measures including margin requirements may reduce the effects of market disruption.

6. Cross-Margininq

6.1 Cross-margining may be defined as the practice of reducing the total margin payment of a market participant by allowing participants who trade in related products and possibly on more than one market (for example, the cash and derivative markets) to recognize reduced risks associated with offsetting open positions (i.e., where a decrease in a position's value in one market is likely to be offset by a gain in a corresponding position's value in another market).

6.2 Generally, cross-margining has been practiced as between cash

and options products, or options and futures products.

6.3 Although not prohibited, cross-margining is not practiced in Australia, Spain, Italy, Japan, or Mexico. However, in the jurisdictions where it is practiced, such as the United States, Canada, Germany, the Netherlands, Switzerland, and France, cross margining, across instruments and/or markets, is subject to certain conditions, limitations and/or specified agreements among regulators. In the Netherlands, market authorities permit offsetting positions to be located outside the country if they have the same underlying value. In Italy, market authorities currently are in the midst of establishing cross-margining procedures for a wider variety of financial instruments.

6.4 In several other countries where the options and futures markets are one, cross-margining is practiced across products.

Footnote:

1. In Germany, the United Kingdom, Japan and France, creditworthiness is important but is not specifically taken into account when establishing margin levels