Daily reset

What Is Daily Reset?

The daily reset, in the context of financial markets, refers to the process by which a clearing house or exchange revalues open positions in futures contracts, derivatives, and other margined products at the end of each trading day. This practice, a core component of derivatives trading and market infrastructure, involves marking positions to market, calculating daily gains or losses, and adjusting margin requirements. It is a critical mechanism for risk management that ensures financial obligations are met promptly, thereby reducing systemic risk across financial markets. The daily reset impacts all market participants holding open positions, from individual traders to large institutions and hedge funds.

History and Origin

The concept of daily revaluation and managing risk through intermediate payments dates back to the establishment of early clearing mechanisms. While modern derivatives markets and the formalized daily reset are products of the late 19th and 20th centuries, the fundamental idea originated with the need to settle transactions efficiently and mitigate counterparty risk. Early forms of clearing houses emerged in the 18th century for interbank check clearing, such as the London Clearing-House around 1750–1770, which centralized the exchange of checks and bills., A⁶s financial exchanges developed, particularly for commodities and stocks, the need for a mechanism to ensure trade integrity became paramount. The first dedicated clearinghouse in the United States, the New York Clearing House, was established in 1853 to streamline check settlements among banks., ⁵T⁴he principles of centralizing and standardizing transactions to reduce costs and risks later extended to futures and options. The development of futures exchanges and the subsequent expansion of derivative instruments necessitated a robust system for daily reconciliation, leading to the formalized daily reset processes employed by exchanges and clearing houses globally.

Key Takeaways

• The daily reset is a fundamental process in derivatives markets where open positions are revalued at the end of each trading day.
• It involves marking positions to market, determining daily profits or losses, and adjusting required collateral in the form of margin.
• This mechanism significantly reduces counterparty risk and promotes market integrity by ensuring financial obligations are settled daily.
• The process contributes to price transparency and serves as a basis for price discovery in futures and options markets.
• Failure to meet a margin call triggered by a daily reset can lead to forced liquidation of positions.

Formula and Calculation

The daily reset primarily relies on the mark-to-market (MTM) calculation. This involves valuing all open positions at their current market price—specifically, the official daily settlement price determined by the exchange.

The daily profit or loss (P&L) for a given position is calculated as:

$\Delta P\&L = (P_{current} - P_{prev}) \times S$

Where:

• (\Delta P&L) = Change in Profit or Loss for the day
• (P_{current}) = Current day's settlement price (Daily Reset Price)
• (P_{prev}) = Previous day's settlement price
• (S) = Size of the contract (e.g., number of units per contract)

For example, in a futures contract, the settlement price is used to calculate the variation margin, which is the amount of money transferred between buyer and seller to reflect the daily gains or losses. This mechanism ensures that neither party accumulates significant unsettled liabilities.

Interpreting the Daily Reset

The daily reset provides a clear, transparent snapshot of a trader's financial standing in the derivatives market. By applying the daily settlement price to all open positions, the clearing house can accurately calculate the accrued profits or losses for each account. If a position has gained value, the account will be credited; if it has lost value, the account will be debited, potentially leading to a margin call. This daily reconciliation minimizes the accumulation of credit risk, as losses are covered and gains are realized incrementally, rather than waiting until contract expiration. The settlement prices themselves are crucial for other market metrics, such as calculating trading volume and open interest.

Hypothetical Example

Consider an investor who enters a long position in a single crude oil futures contract, representing 1,000 barrels, at a price of $80.00 per barrel. The initial margin requirement is $5,000, and the maintenance margin is $4,000.

Day 1: Initial Trade

• Entry Price: $80.00
• Initial Margin Deposited: $5,000

Day 2: Market Moves Favorably

• End-of-day daily reset price: $81.50
• Daily P&L: ((81.50 - 80.00) \times 1,000 = $1,500)
• The investor's account is credited $1,500. Their account balance is now $5,000 (initial margin) + $1,500 (P&L) = $6,500. No margin call is issued as the account balance is above the maintenance margin.

Day 3: Market Moves Unfavorably

• End-of-day daily reset price: $78.00
• Daily P&L: ((78.00 - 81.50) \times 1,000 = -$3,500)
• The investor's account is debited $3,500. Their account balance is now $6,500 (previous balance) - $3,500 (P&L) = $3,000.
• Since the account balance of $3,000 is below the maintenance margin of $4,000, a margin call is issued by the brokerage firm for $2,000 (($5,000 - $3,000)) to bring the account back to the initial margin level. If the investor fails to deposit the additional funds, their position may be liquidated.

Practical Applications

The daily reset is indispensable in various aspects of financial markets:

• Derivatives Trading: It is the core mechanism enabling the efficient functioning of futures, options, and cleared swaps markets. The Commodity Futures Trading Commission (CFTC) oversees these markets in the U.S., emphasizing the importance of daily settlement for market integrity and participant protection.,
• ³ Risk Mitigation: By adjusting positions and requiring immediate payment of losses, the daily reset significantly reduces counterparty risk. This continuous collateralization minimizes the risk of a market participant defaulting on a large accumulated debt.
• Central Counterparty (CCP) Operations: Clearing houses, often acting as a central counterparty (CCP), sit between buyers and sellers, guaranteeing trades. The daily reset is how CCPs manage their exposure to the default of any single participant, as they "step in" to ensure the completion of trades.
• Liquidity Management: For market participants, the daily reset dictates their daily cash flow needs related to variation margin payments. Periods of high volatility can lead to substantial margin calls, demanding significant liquidity from traders. For example, a sharp rise in derivatives margin calls due to market volatility was reported, highlighting the operational and liquidity risks amplified by abrupt market shocks.

##² Limitations and Criticisms

While the daily reset is crucial for market stability, it does come with certain limitations and criticisms:

• Liquidity Demands: The most significant drawback is the potential for substantial and sudden liquidity demands on traders, especially during periods of high market volatility. Large adverse price movements can trigger sizable margin calls that market participants must meet quickly, sometimes within hours. Failure to do so can lead to forced liquidation of positions, regardless of the trader's long-term outlook. This can exacerbate market downturns if many participants face similar pressures simultaneously.
• Procyclicality: The mechanism can be procyclical, meaning it can amplify market swings. During rapid declines, increasing margin calls can force more selling, pushing prices further down. Conversely, during rapid rallies, reduced margin requirements might encourage more buying.
• Operational Burden: For high-volume traders or large institutions, managing the daily transfer of collateral and responding to numerous margin calls constitutes a significant operational burden, requiring robust treasury and risk management systems.
• Lack of Flexibility: Unlike some over-the-counter (OTC) derivatives that might have more flexible collateral arrangements, exchange-traded derivatives and their daily reset mechanisms offer less room for negotiation on margin requirements.

Daily Reset vs. Settlement Price

While closely related, the "daily reset" describes the overall process and adjustment of accounts, whereas the "settlement price" is a specific numerical value used within that process.

The daily reset uses the settlement price to "reset" the financial obligations between the clearing house and market participants, ensuring that gains and losses are accounted for on a day-to-day basis.

FAQs

How does the daily reset protect the market?

The daily reset protects the market by ensuring that traders cover their losses on a daily basis, rather than letting large debts accumulate. This mechanism, overseen by entities like the clearing house, drastically reduces the risk of counterparty default, maintaining the financial integrity of the system.

What happens if I can't meet a daily reset margin call?

If you cannot meet a margin call generated by the daily reset, your brokerage firm or futures commission merchant will typically liquidate (close out) some or all of your open positions to cover the shortfall. This prevents further losses and protects both the clearing house and the brokerage from potential defaults.

Is the daily reset the same for all financial instruments?

No, the specifics of the daily reset can vary depending on the financial instrument and the exchange or clearing house involved. While the underlying principle of marking to market is consistent, the timing, calculation methodologies, and types of collateral accepted can differ across different markets, such as equities, bonds, or commodities. For example, the CME Group provides specific daily settlement procedures for various asset classes like metals, energy, and agricultural futures.¹