marginfi is a decentralized margin protocol for trading across Solana. The protocol makes it easy for traders to access margin, manage risk, and improve capital efficiency across the entire Solana ecosystem from one unified place.
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This article is a continuation of the marginfi Leverage (learning) series.
Hello Traders! We last talked about cross-margin and how it allows traders to easily maintain margin requirements. Today we’ll dive deeper into those requirements and how they have been set over the years.
Initial and Maintenance Margin
As we previously talked about, positions have mandatory margin which helps fulfill counterparty obligations and cover the exchange’s losses. This position level margin requirement can be further broken into initial margin and maintenance margin. Initial margin is the amount of margin needed to open the position and maintenance margin is the amount of that initial margin that must still be in the position to avoid liquidation.
These requirements have been calculated by three main methodologies over the years. The methodologies are built on two different approaches: rules-based and risk-based.
Rules-Based vs Risk-Based
Rules-based approaches use a uniform set of “rules” to determine margin requirements. This may be something like a flat rate or percentage of the position. These are generally very easy to calculate but can often under or overestimate the risk of a given position. Rules-based margin requirements also have no inter-product offsets. This means that the positions are viewed individually without regard for how positions may be risky relative to each other or within the context of an entire portfolio.
Risk-based methods use different data on specific assets to benchmark their risk. This leads to dynamic margin requirements which can shift rapidly with changes in the underlying. These are much more mathematically demanding but often provide a more holistic and accurate view of the risk of a position or portfolio.
Let’s take a look at the most common pillars for each approach.
One of the first instances of margin requirements came about with Regulation T or “Reg T” as it is often referred to. This rules-based approach was created by the Federal Reserve to regulate investors’ cash accounts. It stipulates that investors may borrow up to 50% of the purchase price of an asset from the broker/dealer/exchange. The “rule” here is 50% max LTV. Reg T further stipulates that a position must maintain a 25% maintenance margin. This means that if half of the initial margin is lost, the position is at risk of being liquidated by the exchange if no new margin is added.
This approach is straightforward and predictable for investors but it does not allow for much exposure. In contrast, risk-based methods are dynamic and can offer higher leverage.
Risk-based methods look at the historical movement of an asset to determine margin requirements. These methods also view a portfolio in aggregate rather than by position (“portfolio margin”). This helps predict how positions may move with or against each other and how that will in turn affect the risk of the entire portfolio.
This creates “inter product offsets” which account for how positions can move conversely with each other. Under a rules-based approach, one of these opposing positions may be liquidated. By viewing the total portfolio under a risk-based approach, the real risk is better understood. This is advantageous to traders, especially those creating complex options strategies.
The Theoretical Intermarket Margining System, or TIMS, is one of the simplest risk-based approaches. TIMS was created by the SEC to create regulations and guidelines for portfolio margining. This system is unique because it is a bit of a hybrid of both approaches to margin requirements. TIMS is ultimately a rules-based system but these rules are determined by risk.
It is structured by creating tiers of assets and then bundling the positions related to the same underlying by “class.” The tiers categorize assets by risk. In tradfi, a market index would be in the lowest risk tier and a tech stock would be in the highest risk tier. These groupings determine the bands the positions are stressed tested within. For example, an index will be tested between an 8% drawdown and a 6% increase while the tech stock will be tested between a 15% move in either direction. More on this here.
The system is considered portfolio margin because all of the positions tracking the same underlying will be viewed together or in aggregate. TIMS classifies assets based on their risk and outputs how much margin is required based on the expected max movement.
The gold standard for risk-based margin requirements is the standardized portfolio analysis of risk or “SPAN” margin. The methodology calculates risk daily to understand what is the largest theoretical one-day loss the portfolio could incur. It uses a variety of sophisticated algorithms to compute these drawdowns and adjust requirements accordingly.
While this system is more complicated it is almost necessary for any derivatives platform. Calculating risk on a spot position is simple because money is borrowed from the protocol and there is a clear cutoff to where the trader could no longer cover the position. Options and futures are much less linear and as such require a more complicated methodology to manage requirements.
If you want to geek out on how these algorithms actually work, check out the CME’s info on how their in house SPAN margin system works.
Putting it all together
These are the three main methodologies to calculate margin requirements. Each one builds on the ideas of the last to better understand risk and allow for higher leverage. The key differences are:
We’re almost through with our introduction to margin. Margin trading presents the opportunity for outsized returns but these come at a cost! Next we’ll dive into the risk associated with margin and why this type of trading may not be suitable for everyone.
As always, no marginfi content should ever be considered financial advice and no reference to financial assets, securities, derivatives, or other financial products should be considered an endorsement of the aforementioned. Please consult a licensed financial advisor before making any and all investment decisions, and please do your own research.