Quick Answer
On an uncompleted inter-member contract, the exposed member may demand collateral for the adverse price difference. Permitted deposit locations have specific conditions. Proper written demands require immediate compliance; excess collateral is refundable on demand. Failure can permit close-out, but not before regular delivery hours end on the business day after the demand.
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 with the demanding member or another permitted location |
| 6 | Further adverse movement can support an additional deposit demand |
| 7 | If the market reverses, the depositor may demand return of the excess |
Where the Funds Can Be Held
The inter-member mark rule permits a deposit:
- Directly with the demanding member
- With a mutually agreed depositary
- If the parties cannot agree, with a Federal Reserve System member at an office in the financial district of the city where the unsecured party maintains its office
The depositing party cannot select any third party or bank unilaterally. The agreement and location conditions matter.
Update Frequency
Daily monitoring is a sensible risk-control practice, but the inter-member mark rule does not mandate a daily review cadence. Procedures should identify exposure, support additional demands as prices move, and ensure immediate compliance with proper written demands for deposits or refunds.
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 | Close-out may follow, but not before the end of regular delivery hours on the business day following the demand |
| 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.
- Alternative deposit locations have conditions. A depositary must be mutually agreed; the Federal Reserve member alternative has disagreement and office-location requirements.
- Proper written demands require immediate compliance. Daily monitoring is useful practice, not a mandatory rule-based review schedule.
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.
- Excess collateral is refundable on demand when the market reverses. The mark can change before settlement.
What Should You Check on Exam Day?
- Can you identify the permitted deposit locations and the agreement and location conditions for alternatives?
- Do you know what happens if a member fails to deposit a properly demanded mark-to-market deposit?
- Can you distinguish the inter-member mark-to-market rule from customer margin maintenance, and state which counterparty each protects?
- Do you know how often the mark-to-market deposit updates, and what triggers a refund of the deposit?