Closing-out mechanism

What hapens if you can’t pay your margin call?

Here is what happens if you can’t pay your variation margin.

Let’s say that John Doe is a trader, who has been actively trading futures and options. Unfortunately, he was short a decent number of calls on stock ABC, which has just been announced as the target of a hostile take-over. ABC’s stock price immediately gaps 25% up and becomes very volatile at this new level.

That evening, the exchange asks John to deposit $1,000,000 as a margin call. John doesn’t have that kind of money.

1. John has a clearing agreement with CCC, which financially guarantees John’s trading payment to the exchange. John’s clearer pays the $1 million requested by the exchange.

2. John is suspended from trading. If the exchange is physical (with a trading pit), the pit officials will come to him and prevent him from entering the pit area. They simply have to confiscate his badge (the other traders can’t see his trader’s code and can’t trade with him anymore). If the exchange is electronic, John’s login may be deactivated altogether, or he may be able to access the platform to see his trading positions. In any case, the “Buy” and “Sell” buttons are de-activated. He cannot trade anymore.

3. The clearer is now in charge of John’s trading position and liquidates his trading activity. Practically speaking, it means that the clearer’s trading staff will take over the account and close his trading positions. To be even more clear clear, the traders do not ‘reduce the risk’, they buy back every line in his portfolio.

Because the market was already adverse for John and probably still is, the trades are expensive. The liquidity might not be there. But even if the traders pay attention to the prices and the liquidity, they have to close the account quickly, and that’s usually expensive. Let’s say that this closing effort, maybe taking several days, costs an additional 300k$.

If John was actually a large trading house (or a clearer!), the exchange has a special procedure to auction the entire portfolio to other trading houses and market participants. This is what happened to Ronin in March 2020.

4. The clearer sues John to recollect the loss, the entirety of the loss, aka not only the initial 1 million, but also the additional 300 k$ incurred to liquidate the book. The clearer’s legal team is very efficient. The attorneys see those kind of liquidations day-in and day-out. John will be served in a matter of days, maybe weeks. Contractually speaking, the clearer has every right to do so. John’s clearing agreement specifies that they can go after John’s personal assets to recollect the monies.

It may take 2-3 of years from there, but the likely outcome is that John will lose his legal case, will have to pay the $1.3 m, as well as both his and the clearer’s attorney fees. If he has a house, he will lose it.

The conclusion is that the exchange and its clearing mechanism are extremely efficient at collecting unpaid margin calls.

If you trade on a derivatives exchange, your profits will be paid to you, or you will pay your loses with your house.

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