Cleared derivatives are generally characterized as being either “collateralized-to-market” (“CTM”) or “settled-to-market” (“STM”) in connection with the mitigation of counterparty credit risk resulting from movements in mark-to-market value. Under the CTM approach, transfers of variation margin are characterized as daily “collateral” transfers, with the transferring party having a right to reclaim the collateral (a financial asset) and the receiving party having the obligation to return the collateral (a financial liability), as well as a legal right to liquidate the collateral in the event of a close-out.

Under the STM approach, variation margin reflects daily “gain” to the receiving party that is actually settled. Despite the settlement of the gain on a daily basis, the derivative’s underlying economic terms remain the same (in other words, there is no amendment or recouponing of the trade).  However, unlike the CTM approach, variation margin transferred is not regarded as pledged collateral securing obligations between the parties.  Rather, variation margin is deemed to “settle outstanding exposure” between them (with no right to reclaim or obligation to return the variation margin) and, after that settlement, the mark-to-market between the parties resets to zero. READ MORE →