Explain what margin and a clearing house do
The idea
A central counterparty interposes itself between buyer and seller, becoming the buyer to every seller and the seller to every buyer, so neither party is directly exposed to the other's solvency, being exposed to the clearing house instead, which relies on margin and a default fund. It protects itself with initial margin, posted at the outset to cover a plausible one-day move, and variation margin, which settles the day's gain or loss in cash. If the account falls below the maintenance level, a margin call restores it to the initial level under the usual convention — not to the maintenance level, which is a detail that trips up many candidates.
A practice question
What is the function of initial margin on a futures position?
- It is the premium paid for the contractWhy not: Futures have no premium; the trader's margin remains their own money and is returned when the position closes.
- It is a good-faith deposit covering a plausible adverse move — correct
- It is the final settlement of the contractWhy not: Settlement happens daily through variation margin and finally at expiry. Initial margin is a deposit held throughout.
Initial margin is collateral, not a cost. It is returned when the position is closed, adjusted for accumulated gains and losses.
A harder one
An account falls below its maintenance margin level. To what level must it be restored?
- The maintenance margin levelWhy not: Topping up to maintenance would leave the account at the trigger, so the next adverse tick would breach it again.
- Half the initial margin levelWhy not: No such rule exists; the top-up is to the full initial level.
- The initial margin level — correct
The maintenance level is a trigger, not a target. Topping up only to the trigger would produce another call on the next adverse tick.
The hardest tier
How does a central counterparty change the credit structure of a derivatives market?
- It replaces a web with one entity — correct
- It removes credit risk entirely from the financial systemWhy not: It concentrates the risk rather than removing it, which is why the clearing house's own margin model matters so much.
- It guarantees that no participant can defaultWhy not: Participants still default. What the structure changes is who bears the consequences.
Bilateral exposures become exposure to a single, margined and capitalised counterparty. Default risk is concentrated and collateralised rather than eliminated, which is why the capitalisation and risk management of the clearing house itself become systemically important.
In the app: 9 practice questions on this outcome, a narrated walkthrough with diagrams, spaced review that brings it back before you forget it.
Take the free diagnostic →