Incremental maintenance margin

What Is Incremental Maintenance Margin?

Incremental maintenance margin refers to the additional capital a trader must deposit into a margin account to meet a revised or increased minimum equity requirement set by a broker-dealer or clearinghouse. This concept falls under the broader financial category of risk management in leveraged trading. While "incremental maintenance margin" is not a formal, universally defined margin type, it describes the circumstance where an existing maintenance margin requirement is increased, necessitating further deposits to maintain open positions. It is distinct from the initial margin required to open a position and the standard maintenance margin that must be held under normal market conditions. An incremental maintenance margin demand typically arises due to adverse price movements in the underlying securities or derivatives, leading to a shortfall in the account's equity.

History and Origin

The concept of margin requirements has evolved significantly, particularly following periods of pronounced market instability. Margin trading, which allows investors to use leverage by borrowing funds to purchase securities, gained prominence in the early 20th century. However, the lack of stringent regulation contributed to excessive speculation and amplified losses during the 1929 stock market crash, which, in turn, fueled the Great Depression. In response, the United States introduced its first margin requirements in the 1930s to mitigate systemic risk.¹⁹ The Federal Reserve Board, under Regulation T, was granted authority to set initial margin requirements for securities purchases.¹⁸

Over time, regulatory bodies like the Securities and Exchange Commission (SEC) and the Financial Industry Regulatory Authority (FINRA) have established comprehensive rules governing margin accounts and requirements, including maintenance margins.¹⁶, ¹⁷ For instance, FINRA rules typically mandate a maintenance requirement of at least 25% of the total market value of securities purchased on margin.¹⁵ For derivatives, such as futures contracts and options contracts, central counterparty clearinghouses (CCPs) like CME Clearing utilize sophisticated methodologies, such as the Standard Portfolio Analysis of Risk (SPAN), to calculate performance bond requirements, which are often referred to as margins.¹³, ¹⁴ These methodologies are continuously enhanced to account for various market scenarios and risk factors.¹² The need for an incremental maintenance margin arises when these dynamic calculations, driven by market changes, dictate that additional collateral is necessary to uphold the required equity level.

Key Takeaways

• Incremental maintenance margin refers to the additional funds required to satisfy an increased minimum equity level in a margin account.
• It is triggered by adverse market movements, heightened market volatility, or changes in a broker's risk assessment.
• Failure to meet an incremental maintenance margin demand, often issued as a margin call, can lead to the forced liquidation of positions.
• It serves as a critical risk management tool for broker-dealers and clearinghouses to protect against counterparty default.
• The calculation of incremental maintenance margin is typically the difference between the new, higher maintenance margin requirement and the existing equity in the account.

Formula and Calculation

The incremental maintenance margin is not a standalone formula but rather a calculation that determines the additional funds needed to bring an account's equity up to a new, higher maintenance margin requirement.

Given:

• ( \text{EMV} ) = Equity Market Value (current market value of securities in the margin account minus the amount owed to the broker)
• ( \text{MMR}_{\text{new}} ) = New Maintenance Margin Requirement (the percentage of the total market value of securities that must be maintained as equity, as revised)
• ( \text{TMV} ) = Total Market Value of securities in the account

The required equity for the new maintenance margin is:
$\text{Required Equity} = \text{MMR}_{\text{new}} \times \text{TMV}$

If the current equity market value (( \text{EMV} )) falls below this new required equity, an incremental maintenance margin is needed. The formula for the incremental maintenance margin would then be:

$\text{Incremental Maintenance Margin} = \text{Required Equity} - \text{EMV}$

This represents the additional collateral that must be deposited. It's crucial to distinguish this from the initial margin which is required to open a position.

Interpreting the Incremental Maintenance Margin

An incremental maintenance margin demand signals an increased level of risk associated with a trader's leveraged positions. When a broker issues a request for an incremental maintenance margin, it means the existing equity in the margin account is no longer sufficient to cover potential losses given current market volatility or specific price movements.

The size of the incremental maintenance margin relative to the account's existing equity can indicate the severity of the situation. A large incremental requirement suggests significant adverse price movements against the trader's positions or a substantial increase in the perceived risk by the broker or clearinghouse. Traders must interpret this as an urgent need to either deposit additional funds, reduce their leverage by closing some positions, or face potential forced liquidation of their holdings. This mechanism is crucial for the financial health of both the trader and the financial institution providing the margin.

Hypothetical Example

Consider an investor, Sarah, who opens a margin account to purchase 1,000 shares of XYZ Corp. at $100 per share, totaling $100,000. Her broker requires an initial margin of 50% ($50,000) and a maintenance margin of 30% ($30,000).

After a week, XYZ Corp.'s stock price drops to $70 per share.

• The total market value of her shares is now $70,000 (1,000 shares x $70).
• Sarah initially borrowed $50,000 from her broker ($100,000 purchase price - $50,000 initial margin). This loan amount remains constant.
• Her equity in the account is now $20,000 ($70,000 current market value - $50,000 loan).

The broker's maintenance margin requirement is 30% of the current market value:

• Required maintenance equity = 30% of $70,000 = $21,000.

Since Sarah's current equity ($20,000) is below the required maintenance equity ($21,000), her broker issues a margin call. The amount of this incremental maintenance margin is the difference:

• Incremental Maintenance Margin = $21,000 - $20,000 = $1,000.

Sarah must deposit an additional $1,000 into her account to bring her equity back to the maintenance requirement. If the broker's policy is to bring the account back to the initial margin level upon a margin call, the incremental amount would be even higher.

Practical Applications

Incremental maintenance margin requirements play a vital role across various financial sectors, primarily in managing counterparty credit risk.

• Brokerage Firms: For retail and institutional traders using margin accounts, broker-dealers continuously monitor account equity against maintenance margin levels. A sudden drop in the value of securities held on margin due to market volatility will trigger an incremental maintenance margin requirement.
• Derivatives Markets: In futures contracts and options contracts, clearinghouses like CME Clearing manage billions of dollars in open interest daily. They employ sophisticated risk models, such as SPAN, to calculate performance bonds (margins) that cover potential losses.¹⁰, ¹¹ If market conditions change rapidly, increasing the risk of positions, the clearinghouse may dynamically adjust its margin parameters, leading to an incremental maintenance margin demand from its clearing members. CME Group, for example, proactively adjusts collateral requirements to manage volatile conditions.⁹
• Over-the-Counter (OTC) Derivatives: Following the 2008 financial crisis, there has been a global push for more stringent margin requirements for non-centrally cleared OTC derivatives.⁷, ⁸ Regulatory bodies and industry groups, including the Basel Committee on Banking Supervision (BCBS) and the International Organization of Securities Commissions (IOSCO), developed standards for initial and variation margin for these products.⁶ These rules, implemented in phases, aim to reduce systemic risk by ensuring that market participants exchange collateral to cover exposures.⁴, ⁵ An incremental maintenance margin requirement here would reflect a re-evaluation of the potential future exposure on such bilateral contracts, demanding additional collateral from counterparties.

Limitations and Criticisms

While incremental maintenance margin demands are crucial for risk management, they are not without limitations and criticisms. One significant concern is their potential to amplify procyclicality in financial markets. During periods of high volatility or economic downturns, declining asset prices trigger widespread margin calls, including demands for incremental maintenance margin. This forces investors to either liquidate positions to meet these calls or deposit additional capital. Such forced selling can further depress prices, creating a downward spiral and exacerbating market stress.³

Academics and regulators have discussed whether margin requirements, when aligned closely with volatility, can lead to a build-up of excess leverage in calm periods and forced deleveraging in turbulent times.² Some argue that while central counterparty clearing (CCP) for derivatives enhances safety, large variation margin calls, which effectively act as continuous incremental adjustments, can place significant liquidity demands on market participants, potentially outweighing the impact of changes in initial margin.¹ Additionally, in less liquid markets, meeting an incremental maintenance margin can be particularly challenging, potentially leading to disorderly unwinding of positions and further market disruption.

Incremental Maintenance Margin vs. Maintenance Margin

The primary difference lies in the nature of the requirement: maintenance margin is the baseline minimum, while incremental maintenance margin represents an increase to that baseline, demanding more capital than what would typically be required to simply bring the account back to the original maintenance threshold.

FAQs

Q1: What causes an incremental maintenance margin requirement?

An incremental maintenance margin requirement is typically caused by significant adverse price movements of the securities or derivatives held in a margin account, or by a broker-dealer or clearinghouse increasing its general margin requirements due to heightened market volatility or increased risk perception.

Q2: Is an incremental maintenance margin the same as a margin call?

An incremental maintenance margin is often the amount requested in a specific type of margin call. A margin call is a general request for additional funds to bring an account back to its required margin level. When the required maintenance level itself increases, the amount requested to meet that new, higher threshold would be an incremental maintenance margin.

Q3: What happens if I cannot meet an incremental maintenance margin?

If you cannot meet an incremental maintenance margin demand, your broker-dealer has the right to liquidate positions in your margin account to cover the shortfall, often without prior notice. This forced liquidation can result in significant losses and may occur at unfavorable prices, potentially exceeding your initial investment.

Q4: How can I avoid incremental maintenance margin requirements?

To avoid incremental maintenance margin requirements, traders can manage their leverage conservatively, maintain sufficient excess equity in their margin accounts, and closely monitor market conditions and the performance of their positions. Diversifying a portfolio can also help mitigate the impact of adverse movements in a single security.