Portfolio Margining: Strategy vs Risk ∗ E. G. Coffman, Jr. † D. Matsypura ‡ V. G. Timkovsky ‡ June 8, 2009 Abstract Introduced in the late eighties for margining certain accounts of brokers, the risk- based 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. 1 Introduction “We still have a 1930s regulatory system in place. We’ve got to update our institutions, our regulatory frameworks, . . . ”. . . the banking system has been “dealt a heavy blow,” the result of “lax regulation, massive overleverage, huge systematic risks taken by unregulated institutions, as well as regulated institutions.” – Barack Obama 1 In the margin accounts of investors, i.e., customers of brokers, margin payments are based on established minimum margin requirements which depend on a large number of factors, such as security type, market price, expiry date, rating and other character- istics of securities held in the positions of the accounts. They are the subject of margin regulations. Margin rules exist for margining single positions, small groups of posi- tions like those in trading strategies and entire portfolios of positions with a common underlying instrument or strongly correlated underlying instruments. ∗ The paper was prepared when the first coauthor was visiting Faculty of Economics and Business at The University of Sydney, Australia. † Columbia University, NY 10027, USA, coffman@cs.columbia.edu. ‡ University of Sydney, NSW 2006, Australia, {d.matsypura,v.timkovsky}@econ.usyd.edu.au. 1 From “Obama, Brown call for global changes, say financial regulations need to be revamped” by Roger Runnigen and Robert Hutton, Bloomberg News, p. 4A · MARCH 4, 2009 · USA TODAY. 1