Meaning
Collateral deposits required before a derivative or physical supply transaction executes protect the trading relationship against the risk of sudden defaults. To secure open positions, initial margin must be posted by both counterparties at the inception of the contract. This asset buffer is held in a segregated account to ensure it remains available if a participant goes bankrupt.
It acts as a primary line of defense against market volatility and potential contract cancellation.
Collateral Requirement
Only highly liquid assets, such as cash or top-tier government securities, are acceptable to satisfy these requirements. These assets are subject to standard valuation discounts to account for potential market declines during periods of stress. The level of required collateral depends on the historical volatility of the underlying commodity or instrument.
Agreements dictate that these deposits must remain untouched for the duration of the transaction.
Funding Expense
The commitment of capital to margin accounts increases the cost of doing business for distributors and trading firms. This capital cannot be used for operational expenses, product development or inventory expansion. It represents an opportunity cost that must be factored into the overall pricing of supply agreements.
Suppliers must balance the security of cleared transactions against the cash constraints of high margin requirements.
Distribution Impact
Wholesale distributors face strict demands to secure their hedging transactions. When collateral requirements rise, firms may reduce the volume of goods they commit to distribute. This defensive measure prevents liquidity shortages.
