Marking to the Market
Quick Answer
The mark-to-market rule lets one party to an uncompleted contract (a trade that has not yet settled) demand a deposit from the contra-party when the market price has moved against the contra-party. The deposit equals the difference between the contract price and the current market price. The funds may be deposited directly with the demanding member, with a third-party depository, or with a member of the Federal Reserve System. The mark is updated periodically (preferably daily) as the market continues to move. A party that fails to deposit when properly demanded may be subject to close-out under the close-out framework. This is inter-member mark-to-market on open contracts, NOT customer margin.
The mark-to-market rule is the inter-member mechanism for managing counterparty credit exposure on trades that have not yet settled. The principal supervising operations sees both the inter-member mark (street-side, between members) and customer margin (covered separately) operating in parallel.
How Marking to the Market Works
When two members enter into a contract for the purchase or sale of a security and the trade has not yet settled, the contract carries counterparty exposure. If the market price moves between trade date and settlement date, one member is now exposed to a loss if the contra-party defaults.
Mark-to-Market Deposit Sequence
The mark-to-market rule lets the exposed member demand a mark-to-market deposit from the contra-party. The mechanic:
| Step | Action |
|---|---|
| 1 | Two members trade at a contract price (e.g., $50.00) |
| 2 | The market moves before settlement (e.g., current market is now $48.00) |
| 3 | The seller is exposed: the buyer has a $2.00 paper loss and could walk away from the trade |
| 4 | The seller may demand a mark-to-market deposit equal to the loss ($2.00 per share × quantity) |
| 5 | The buyer deposits the funds with the seller, a third-party depository, or a Federal Reserve member |
| 6 | If the market moves further, the mark is updated periodically (preferably daily) |
| 7 | If the market moves back in the buyer's favor, the deposit (or excess) is refunded |
Where the Funds Can Be Held
The depositing party has three options for where to place the funds:
- Directly with the demanding member
- With a third-party depository
- With a member of the Federal Reserve System
The choice is operational. The deposit is collateral, not a transfer of ownership.
Update Frequency
The mark is updated periodically, preferably daily. As the market moves, the deposit is recalculated and either topped up or refunded. The principal must verify the firm's WSPs specify the update frequency and the operational steps.
When Failure to Deposit Triggers Close-Out
If a party fails to deposit the mark when properly demanded, the demanding member may close out the trade under the close-out framework (covered in the next section). Failure to mark is a default event.
The sequence:
| Step | Action |
|---|---|
| 1 | Demanding member properly demands a mark deposit |
| 2 | Contra-party fails to deposit within the time specified |
| 3 | Demanding member may issue a buy-in or sell-out notice |
| 4 | The defaulting party owes any difference between the close-out price and the original contract price |
Exam Tip: Gotchas
- Failure to deposit a properly demanded mark = default; close-out applies. A firm cannot ignore the demand and continue carrying the trade.
- The deposit goes to the demanding member, a third-party depository, OR a Federal Reserve member. Three valid locations.
- The mark is updated periodically (preferably daily) as the market continues to move. Not "weekly," not "at settlement"; daily is the preferred cadence.
Inter-Member Mark vs. Customer Margin Maintenance
The exam pairs the inter-member mark with the customer margin maintenance regime to test the distinction. Both involve mark-to-market and deposit demands, but they operate at different levels:
| Regime | Who | What It Protects |
|---|---|---|
| Inter-member mark | Member to member | The demanding member's exposure on an uncompleted street-side contract |
| Customer margin maintenance | Firm to customer | The firm's exposure on a customer margin account |
The principal supervising operations sees both:
- Customer margin maintenance protects the firm against the customer (the firm calls additional margin when the customer's account equity drops below maintenance)
- The inter-member mark protects one member against another (the member demands a mark when the contra-party's contract is underwater)
A firm with weak inter-member mark procedures has unmarked street-side exposure, exactly the kind that surfaces during a market dislocation. A firm with weak customer-margin procedures has unmarked customer margin exposure.
Think of it this way: Customer margin is internal (firm vs. customer); the inter-member mark is external (firm vs. counterparty). The two operate in parallel but address different risks. The principal supervising operations is responsible for both.
Exam Tip: Gotchas
- The mark-to-market rule is INTER-MEMBER mark-to-market on uncompleted contracts. Customer margin maintenance applies to CUSTOMER accounts. Different parties, different counterparties, different rulebooks.
- A firm can be the demanding party under both regimes at the same time. They do not conflict; they cover different exposures.
- The inter-member mark applies to UNCOMPLETED contracts only. Once the trade settles, the mark-to-market rule no longer applies; the firm's exposure converts to settled-position risk (covered by net capital).
Why This Matters for the Supervisor
The principal supervising operations must:
- Verify the firm's WSPs specify when and how to demand a mark
- Verify the firm has procedures to deposit a mark when one is demanded against the firm
- Track open contracts and current market prices to identify mark-to-market exposure
- Document each mark demand and deposit (records survive for the audit trail)
A firm that sees a contract move underwater and fails to demand a mark is leaving counterparty exposure unmitigated. A firm that has a mark demanded against it and fails to deposit is in default and exposed to close-out.
Exam Tip: Gotchas
- The demanding member CHOOSES whether to demand a mark. The rule is permissive ("may demand"), not mandatory. But a firm that does not demand has not protected itself.
- The mark amount equals the DIFFERENCE between contract price and current market price. Not the full notional value; only the unrealized loss.
- A refund of the deposit is required if the market moves back in the depositing party's favor. The mark is bilateral and dynamic; it can swing both ways before settlement.