In derivatives, two kinds of collateral change hands to cover the risk that a counterparty fails: initial margin and variation margin. Both are called “margin” and are routinely confused, but they do opposite jobs — one settles the loss that has already happened, the other reserves against the loss that might. Since the 2008 crisis, posting both has become mandatory across most of the derivatives market, which cut counterparty risk but tied up collateral and opened a new channel for liquidity stress. This guide explains what each covers, how it is calculated, and why the two come due together in a crisis.
Why margin exists
A derivative is an agreement to exchange value in the future. Between the trade and its settlement the market moves, and one side ends up owing the other. Margin is collateral that protects each party against the other failing to pay. It is what lets two counterparties carry large positions against each other without taking on unlimited credit risk — and since the 2008 crisis, posting it has moved from optional to, in most cases, mandatory. Regulators required it precisely because, before 2008, uncollateralised derivative exposures had let losses cascade from one firm to the next.
Variation margin: the loss already taken
Variation margin (VM) covers losses that have already happened. Each day — sometimes intraday — open positions are marked to market. If your position has lost value, you pay variation margin to the counterparty equal to that loss; if it has gained, you receive it. VM is, in effect, the daily settlement of running profit and loss, and it flows both ways over the life of the trade. Because yesterday’s move has already been collateralised, VM keeps current exposure close to zero. It is almost always paid in cash.
Initial margin: the loss that hasn’t happened yet
Initial margin (IM) is posted up front and covers potential future losses. It is sized to cover how far a position could move against you over the time it would take to close out or replace a defaulting counterparty’s trade. Where VM looks backward at what has happened, IM looks forward at what could. It is calculated with risk models that estimate that potential move, and is usually held separately so it is protected if the counterparty fails. Unlike variation margin, which is settled in cash, initial margin can be posted as cash or as high-quality securities such as government bonds.
Keeping them straight
- Variation margin = the loss that has already occurred. Backward-looking, settled daily, flows both ways, usually cash.
- Initial margin = the loss that might occur. Forward-looking, posted up front, held as a segregated buffer.
Why the distinction matters
The two behave very differently under stress, which is where confusing them gets expensive. Variation margin scales with realised price moves: a sharp swing produces large VM calls, which is a liquidity event — firms must find cash immediately. Initial margin scales with expected volatility: when markets turn turbulent the models demand larger IM buffers, locking up more collateral exactly when it is scarce. The two can hit at once. The market turmoil of March 2020 and the 2022 stress in UK government bonds — which forced pension funds to raise cash against their liability-driven investment hedges — both featured margin calls large and fast enough to force firms into selling assets to raise cash — a reminder that margin, designed to contain risk, can also amplify a liquidity squeeze.
Conclusion
Initial margin and variation margin address the same problem — counterparty default — from opposite ends of time. Variation margin settles the loss that has already happened; initial margin reserves against the loss that might. Since 2008 both have become standard across the derivatives market, which has cut counterparty risk across the system but tied up large amounts of collateral and opened a new channel for liquidity stress. The practical point is to track them separately: one is a daily cash settlement, the other a forward-looking buffer, and in a crisis both come due at the same time.