Portfolio Margining: Strategy vs Risk∗

Introduced in the late eighties for margining certain accounts of brokers, the riskbased approach to margining portfolios with equity derivatives has yielded substan­ tially lower margin requirements in comparison with the strategy-based approach that has been used for margining customer accounts for more than four decades. For this reason, after the approvals of the pilot program on July 14, 2005, and its extensions on December 12, 2006, and July 19, 2007, the final approval of using the risk-based approach to margining customer accounts by the SEC on July 29, 2008, at the time of the global financial crisis, appeared to be one of the most radical and puzzling steps in the history of margin regulations. This paper presents the results of a novel mathematical and experimental analysis of both approaches which sup­ port the thesis that the pilot program could have influenced or even triggered the equity market crash in October 2008. It also provides recommendations on ways to set appropriate margin requirements to help avoid such failures in the future.