In the derivatives world, margin calls are frequently viewed as a routine back-office function. From an operational perspective this makes sense – a margin call is simply a demand from your counterparty (or CCP/Clearing Broker) to provide additional collateral to cover potential losses in a derivatives position. It is triggered when the value of your position moves against you, and the existing collateral is no longer sufficient to meet the minimum requirements. But while margin calls may be operational in nature, they form a critical function in helping firms manage their counterparty credit risk. However, when market volatility hits, these routine calls can escalate into a “perfect storm,” creating a cascade of liquidity challenges that reverberate throughout the financial system. Here, we analyse the dynamics of volatility-driven margin calls, exploring their operational impact, the role of collateral, and the ever-present cost of funding.

A question of eligibility and liquidity

Not all assets are created equal when it comes to collateral. While ‘cash is king’ may be a common sentiment, that may not be the case for all firms, particularly those who face an opportunity cost in holding large cash reserves, such as pension funds. As a result, market participants rely on a diverse range of eligible collateral, which typically includes high-quality and liquid securities such as government bonds, as well as equities and corporate bonds. However, this collateral diversity comes at a cost, with anything other than short-term government debt subject to a larger haircut due to increased price volatility and reduced credit worthiness.

With market volatility comes an increase in margin demands – both in size and volume – the impact of which can lead to collateral shortages for firms, which in turn can lead to a sale of assets to meet any sudden rise in requirements. As witnessed during the UK LDI crisis of 2022, the sale of assets led to a fall in their value, which combined with the increased demand for collateral, created a vicious cycle which created significant liquidity strain on firms, requiring central bank intervention.

The impact of volatility is to magnify liquidity issues which risks spreading the initial shock across the wider market.

The hidden price of protection: The cost of funding

Meeting a margin call isn’t free. The cost of funding is a critical, and often overlooked, component of managing margin obligations. This cost is driven by several factors, particularly in the repo market, which is the primary source of short-term funding for collateral. When volatility increases, firms scramble for cash and high-quality assets, and the repo rate for high-quality collateral can spike. This makes it more expensive for firms to borrow collateral to meet margin calls.

The window to fund margin calls is very limited, with same-day collateral settlement standard in most markets, or extended only as far as T+1 for some non-cash assets. In addition, intra-day volatility can trigger additional calls in Cleared and ETD markets, which may need to be met within hours. In a 2024 speech, the Bank of England’s Nathanael Benjamin highlighted the recurring liquidity strains faced by market participants caused by periodic unrelated market events, including the COVID-19 outbreak, Russian invasion of Ukraine and UK Gilt crisis. While the underlying cause of market disruption was different in each case, the impact was similar – significant increases in margin requirements. Given the cost of funding is a direct reflection of market stress, it may become prohibitive during a crisis thus creating a serious barrier to maintaining positions.

The operational onslaught

High volatility doesn’t just impact prices; it can unleash an operational tsunami. As prices fluctuate, the volume of margin calls may increase dramatically. The sheer volume of margin calls can overwhelm even the most sophisticated operations teams. Furthermore, the size of each call becomes larger as the delta between the position and the collateral widens. The “dash for cash” episode at the outbreak of COVID-19 saw global variation margin requirements required by CCPs surge from a daily average of $25 billion to a single-day peak of $140 billion.

For those firms still reliant on manual call processing, volatility can lead to operational bottlenecks as legacy processes and systems struggle to cope with even the smallest increase in call volumes. Further, the time-sensitive nature of margin calls – with typical deadlines of only a few hours – puts immense pressure on teams. The hurried nature of high-volume margin calls can also lead to disputes over valuation and calculation, adding another layer of operational complexity.

The path forward: Managing the perfect storm

Given the frequency of market volatility in recent years, the impact should be clear to firms. However the pertinent question is whether adequate lessons have been learned? The responsibility is clearly on the shoulders of individual firms, as Nathanael Benjamin stressed that ‘market participants play their part in ensuring exposures are adequately covered, and that they act as an effective first line of defence. And so that central banks can be the last resort, not the first resort.’

How firms respond in order to best prepare for future volatility requires a holistic strategy that integrates risk management, collateral operations, and liquidity planning.

From an operational perspective firms must move beyond a reactive approach to margin calls. While recent regulatory changes have seen increased investment in margin, firms should go further and implement automated workflows that allow them to seamlessly manage spikes in call volumes and cover the entire call lifecycle from calculation to settlement. Standardisation of processes and automation should improve operational readiness, allowing firms to navigate a crisis rather than succumb to it.

Similarly, they should review collateral eligibility options, ensuring that they are not constrained by eligibility limitations, and establish associated funding lines in order to access sufficient collateral.

While firms may not be able to predict when volatility will hit, they should improve stress testing and scenario analysis to simulate the impact, allowing them to gauge the firm’s resilience and identify potential liquidity gaps. This should consider the impact across asset classes and for both VM/IM.

In conclusion, volatility-driven margin calls are a powerful force in financial markets, capable of transforming a routine risk management process into a major source of systemic risk. The ability to manage this challenge is not just about having the right collateral, but also about the operational resilience to handle the volume, the financial foresight to manage the cost of funding, and a strategic approach to liquidity management. As markets continue to evolve, these capabilities will become increasingly important for survival and success.