Margin System

Diffusal uses a portfolio margin system inspired by CME SPAN (Standard Portfolio Analysis of Risk). Unlike isolated margin where each position is collateralized independently, portfolio margin allows netting of positions and calculates collateral requirements based on worst-case portfolio loss under stress scenarios.

Cross-Margin Architecture

Users do not collateralize individual positions. Instead, all positions share a single collateral pool. Each series has four distinct instrument types created in pairs, enabling capital efficiency: a long call can offset some risk from a short put, and premium receivables offset premium obligations.

Portfolio Equity Calculation

The core health metric is Portfolio Equity:

Option Value

For each position, option value is the current mark price times the option balance:

• Long positions (optionBalance > 0): Positive value (asset)
• Short positions (optionBalance < 0): Negative value (obligation)

Premium Balance

Premium balances represent deferred settlement obligations:

• premiumBalance > 0: User is OWED at settlement (receivable, increases equity)
• premiumBalance < 0: User OWES at settlement (obligation, decreases equity)

Premium is an actual obligation that directly affects equity. It accumulates across trades:

• Buyer: premiumBalance -= price × size
• Seller: premiumBalance += price × size

Deferred Settlement

Important: Deposits do NOT change when opening positions:

• At trade time: Option and premium balances updated; only fees transferred (premium is deferred)
• During holding: Equity = Deposit + (mark × optionBalance) + premiumBalance
• At settlement: Net settlement = (intrinsic × optionBalance) + premiumBalance

Example

See Worked Examples below for detailed equity calculations demonstrating how Option Value and Premium Balance combine to determine portfolio equity.

Portfolio Equity vs Deposited Cash

An important distinction: Portfolio Equity includes the mark-to-market value of positions (Option Value + Premium Balance), while Deposited Cash is only the actual USDC in the vault.

Why This Matters

A user can have:

• High portfolio equity from profitable long positions (paper gains)
• Low deposited cash (minimal USDC actually in the vault)
• Expiring positions with settlement obligations requiring actual cash

The margin system sees a healthy portfolio (Equity ≥ MM), but at settlement the user may not have enough cash to pay obligations.

Example scenario:

Settlement Readiness Liquidation

To handle this gap, the protocol has a separate liquidation mechanism that triggers when:

1. Positions are within 1 day of expiry with net obligations
2. Deposited cash is insufficient to cover worst-case settlement obligations
3. User has liquidatable assets (non-expiring long positions or premium receivables)

This mechanism uses a waterfall approach:

1. First: Liquidate non-expiring LONG positions at penalized mark price
2. Then: If shortfall remains, liquidate premium receivables at a discount (default 5%, max 20%)

This is separate from margin-based liquidation that checks equity vs maintenance margin.

See Liquidation - Settlement Readiness for the full mechanism and worked examples.

Stress Testing (SPAN-like)

The margin system uses stress testing to determine required collateral. We test the corners of the risk space to find worst-case portfolio loss.

Stress Scenarios

We apply shocks to both spot price and implied volatility:

This creates 4 corner scenarios:

4-Corner Stress Testing Diagram

┌──────────────────────────────────────────────────────────────────────────┐
│                            CURRENT STATE                                  │
│  ┌────────────────────────────────────────────────────────────────────┐  │
│  │            Portfolio Value at Current Spot & IV                    │  │
│  └───────────────────────────────┬────────────────────────────────────┘  │
└──────────────────────────────────┴───────────────────────────────────────┘
                                   │
         ┌─────────────────────────┼─────────────────────────┐
         │                         │                         │
         ▼                         ▼                         ▼
┌──────────────────────────────────────────────────────────────────────────┐
│                         4 STRESS SCENARIOS                                │
├─────────────────────────────────┬────────────────────────────────────────┤
│                                 │                                        │
│  ┌───────────────────────┐      │      ┌───────────────────────┐        │
│  │     Scenario 1        │      │      │     Scenario 2        │        │
│  │     Spot: -30%        │      │      │     Spot: -30%        │        │
│  │     IV: +50%          │      │      │     IV: -30%          │        │
│  │  Worst for: Short Puts│      │      │ Worst for: Long Calls │        │
│  └───────────┬───────────┘      │      └───────────┬───────────┘        │
│              │                  │                  │                    │
├──────────────┼──────────────────┼──────────────────┼────────────────────┤
│              │                  │                  │                    │
│  ┌───────────┴───────────┐      │      ┌───────────┴───────────┐        │
│  │     Scenario 3        │      │      │     Scenario 4        │        │
│  │     Spot: +30%        │      │      │     Spot: +30%        │        │
│  │     IV: +50%          │      │      │     IV: -30%          │        │
│  │Worst for: Short Calls │      │      │ Worst for: Long Puts  │        │
│  └───────────┬───────────┘      │      └───────────┬───────────┘        │
│              │                  │                  │                    │
└──────────────┴──────────────────┴──────────────────┴────────────────────┘
               │                                     │
               └───────────────────┬─────────────────┘
                                   │
                                   ▼
┌──────────────────────────────────────────────────────────────────────────┐
│                        MARGIN CALCULATION                                 │
│  ┌────────────────────────────────────────────────────────────────────┐  │
│  │  Stress Loss = max(loss across all 4 scenarios)                    │  │
│  │  IM = Stress Loss + Buffer (5%) + Notional Buffer (15%)            │  │
│  └────────────────────────────────────────────────────────────────────┘  │
└──────────────────────────────────────────────────────────────────────────┘

Why These Values?

• ±30% spot: Captures significant market moves (e.g., crypto flash crashes, major news events)
• +50% IV: Volatility spikes are common during market stress (VIX can double in hours)
• -30% IV: Vol crush after events resolve (post-earnings, post-FOMC)

Stressed Option Loss Calculation

For each scenario:

1. Recalculate all option premiums with stressed spot and IV using Black-Scholes
2. Compute option value change vs current mark
3. Track the maximum loss across all scenarios

Note: The Adverse PnL Buffer is calculated as Stress Loss × 0.05 (5% buffer). Premium balances are NOT stressed—they are deterministic obligations added separately.

Required Margin Calculation

Initial Margin (IM)

Where:

• Stress Loss: Maximum option loss across all 4 stress scenarios
• Adverse PnL Buffer: $\text{Stress Loss} \times 0.05$ — A 5% safety buffer on top of stress loss
• Notional Buffer: $\text{Total Notional} \times 0.15$ — 15% of total option position notional (mark × |optionBalance|)

Important: Notional is based on option position value (mark × optionBalance), NOT underlying asset exposure.

Why Premium is NOT in Margin

Premium balance is included in equity but NOT in margin requirements:

• Premium is deterministic: Unlike option value (which fluctuates with market conditions), premium is a fixed, known amount
• Already reflected in equity: Equity = Deposit + Option Value + Premium Balance — negative premium already reduces equity
• No double-counting: Adding premium to margin would require users to hold extra capital beyond what's needed
• Settlement readiness: A separate mechanism ensures users can pay their premium obligations at settlement

Maintenance Margin (MM)

Health States

Worked Examples

All examples use the following market conditions and option prices.

Reference Data

Market Parameters:

Option Prices (Black-Scholes):

Stressed Prices (used for margin calculations):

Each scenario applies multiplicative shocks to spot and IV.

Standard Entry Prices: Call @ $150, Put @ $120 (used across examples)

Step-by-Step: Stress Testing All 4 Scenarios

For a mixed portfolio with Long 10 Call and Short 5 Put:

User's Portfolio

Note: For short positions, the "position value" represents the current liability — what it would cost to buy back the option to close the position.

Portfolio Value Under Stress

Position value formula: $\text{stressed mark} \times \text{size}$

Note: Long positions are assets (positive). Short positions are liabilities (negative). The short put liability ranges from -$0.20 (best case, near zero) to -$3,555.90 (worst case).

Stress Loss Calculation

Stress loss = Current portfolio value - Stressed portfolio value

Maximum Stress Loss: $4,085.15 (Scenario 1: Spot down, IV up)

Scenario 1 is worst because:

• Long call loses most value (OTM becomes deeper OTM)
• Short put liability increases (put becomes ITM with high IV)

Example A: Long Only (Bounded Margin)

Setup: A user has only long positions with $2,700 USDC deposited.

Option Position:

Premium Position:

Step 1: Calculate Option Value and Premium Balance

Option Value (mark × optionBalance):

Premium Balance:

Step 2: Calculate Portfolio Equity

Step 3: Long Margin Calculation

Under worst-case stress (Scenario 2: spot -30% to $2,100, IV -30% to 35%):

Stressed Option Loss:

Stress Loss + Adverse PnL Buffer:

Notional Buffer:

Initial Margin:

Step 4: Calculate Maintenance Margin

Step 5: Determine Health Status

Result: The position is Healthy.

Key insight: Users with long positions typically also hold Premium Payer positions (a separate instrument). Premium is NOT included in the margin requirement—it's already reflected in equity (reducing equity when negative). This prevents double-counting since the premium obligation is deterministic and known.

Settlement Scenarios:

Using the settlement formula: $\text{netSettlement} = (\text{intrinsic} \times \text{optionBalance}) + \text{premiumBalance}$

Longs CAN be liquidated if their equity falls below maintenance margin.

Example B: Partial Liquidation (Succeeds)

Setup: A user holds a balanced portfolio with $3,200 USDC deposited.

Option Positions:

Premium Positions:

This portfolio is balanced (equal long and short contracts), but still has downside risk from the short puts.

Step 1: Calculate Option Value and Premium Balance

Option Value (mark × optionBalance):

Premium Balance:

Step 2: Calculate Portfolio Equity

Step 3: Calculate Stress Loss + Adverse PnL Buffer

Under Scenario 1 (spot → $2,100, IV → 75%):

• Call value drops: $98.76 → $5.52
• Put value spikes: $80.63 → $711.18

Current Option Value = +$90.65

Stressed Option Value:

Stressed Option Loss:

Step 4: Calculate Notional Buffer

Step 5: Calculate Initial Margin

Step 6: Calculate Maintenance Margin

Step 7: Determine Health Status

Result: The position is Liquidatable.

Partial Liquidation — detailed calculation:

Step 1: Calculate Debt

Step 2: Calculate Target Notional

The protocol uses notional-based partial liquidation:

Step 3: Liquidate Positions (Longest-Dated First)

With equal expiry (30 days), the protocol liquidates the long call first (sorted by position direction, longs before shorts):

Long call position notional: $493.80

Since $493.80 > Target Notional $181.18, only a partial liquidation of the call position is needed:

Step 4: Calculate Position Transfer (1% penalty)

For long calls (1.84 contracts @ $98.76 mark):

User receives $179.90 for their long positions.

Step 5: Calculate Bounty

Step 6: Re-check Health After Partial Liquidation

New deposit: $3,200 + $179.90 - $39.69 = $3,340.21

Remaining positions:

• Long 3.16 calls: $98.76 × 3.16 = $312.08
• Short 5 puts: $80.63 × (-5) = -$403.15
• New Option Value: -$91.07
• Premium Balance: -$150 (unchanged for remaining positions)

New Equity: $3,340.21 + (-$91.07) + (-$150) = $3,099.14

New margin requirements (recalculated with smaller positions):

• Stressed call: $5.52 × 3.16 = $17.44
• Stressed put: $711.18 × (-5) = -$3,555.90
• New Stressed Option Value: -$3,538.46
• New Stress Loss: -$91.07 - (-$3,538.46) = $3,447.39
• New Stress Loss + Buffer: $3,447.39 × 1.05 = $3,619.76
• New Notional: $312.08 + $403.15 = $715.23
• New Notional Buffer: $715.23 × 15% = $107.28
• New IM: $3,619.76 + $107.28 = $3,727.04
• New MM: $3,727.04 × 80% = $2,981.63

Health Check: $3,099.14 ≥ $2,981.63? YES ✓

Result: Partial liquidation succeeded. User retains 3.16 long calls and 5 short puts.

Key insight: The notional-based approach liquidates only the necessary value. Unlike position-count-based liquidation, the protocol supports partial position liquidation — only 1.84 of the 5 calls were liquidated to hit the target notional. The user retains their short put position and most of their long calls.

Example C: Full Liquidation (Partial Fails)

Setup: A user holds a short-heavy portfolio with only $2,500 USDC deposited.

Option Positions:

Premium Positions:

This portfolio is heavily short-biased (5:1 short-to-long ratio), creating significant downside risk.

Step 1: Calculate Option Value and Premium Balance

Option Value (mark × optionBalance):

Premium Balance:

Step 2: Calculate Portfolio Equity

Step 3: Calculate Stress Loss + Adverse PnL Buffer

Under Scenario 1 (spot → $2,100, IV → 75%):

• Call value drops: $98.76 → $5.52
• Put value spikes: $80.63 → $711.18

Current Option Value = -$608.78

Stressed Option Value:

Stressed Option Loss:

Step 4: Calculate Notional Buffer

Step 5: Calculate Initial Margin

Step 6: Calculate Maintenance Margin

Step 7: Determine Health Status

Result: The position is Liquidatable.

Partial Liquidation Attempt:

Step 1: Calculate Debt

Step 2: Calculate Target Notional

Step 3: Liquidate Positions (Longest-Dated First)

With equal expiry (30 days), the long call is liquidated first:

Long call position notional: $197.52

Since $197.52 < Target Notional $601.29, the entire call position is liquidated:

Next, the short put (notional $806.30) is partially liquidated:

Step 4: Calculate Position Transfers (1% penalty)

For long calls (2 contracts @ $98.76 mark):

For short puts (5.0 contracts @ $80.63 mark):

Net cash flow: $195.54 - $407.20 = -$211.66 (user pays)

Step 5: Calculate Bounty

Step 6: Re-check Health After Partial Liquidation

New deposit: $2,500 - $211.66 - $208.80 = $2,079.54

Remaining positions:

• Long 0 calls: $0
• Short 5.0 puts: $80.63 × (-5) = -$403.15
• New Option Value: -$403.15
• Premium Balance: +$900 (unchanged)

New Equity: $2,079.54 + (-$403.15) + $900 = $2,576.39

New margin requirements (recalculated):

• Stressed put value: $711.18 × (-5.0) = -$3,555.90
• New Stress Loss: (-$403.15) - (-$3,555.90) = $3,152.75
• Stress Loss + Buffer: $3,152.75 × 1.05 = $3,310.39
• New Notional Buffer: $403.15 × 15% = $60.47
• New IM: $3,310.39 + $60.47 = $3,370.86
• New MM: $3,370.86 × 80% = $2,696.69

Health Check: $2,576.39 < $2,696.69? STILL UNHEALTHY ✗

Step 7: Escalate to Full Liquidation

Since the user is still unhealthy after partial liquidation, the system escalates to full liquidation:

Liquidate remaining 5.0 short puts:

Final User State:

User retains $1,672.34 but has no positions (fully liquidated).

Key insight: With a 59.9% debt/IM ratio, partial liquidation cannot restore health in this case. The short put positions contribute most of the margin requirement (stress loss), but their current mark value ($80.63) is much lower than their stressed value ($711.18). Even after liquidating 60% of notional, the remaining positions still generate enough stress loss to keep the user underwater. The system correctly escalates to full liquidation.

Example D: Unliquidatable Long Position (With Sufficient Cash)

Setup: A user holds only long positions with sufficient cash (deposit ≥ premium paid) to guarantee they can never be liquidated.

Option Position:

Premium Position:

Deposited collateral: $3,000 USDC

Step 1: Calculate Current State (mark = $98.76)

Option Value:

Equity:

Margin components:

Current health: $2,487.60 > $948.10 ✓ Healthy

Step 2: Calculate Absolute Worst Case (Option Value → $0)

Even worse than the stress scenarios—the options become completely worthless:

Equity at worst case:

Margin at worst case (nothing left to lose):

Worst case health: $1,500 > $0 ✓ Still Healthy!

Mathematical Proof: When Long-Only Positions Cannot Be Liquidated

For long-only positions, the absolute worst case is Option Value → $0 (worse than any stress scenario).

Let $V$ represent option value and $P$ represent premium paid (positive amount):

At any option value $V \geq 0$:

For liquidation: Equity < MM

Key observation: For any $V > 0$, the right side is negative. So liquidation only happens if $\text{Deposit} - P < 0$, i.e., $\text{Deposit} < P$.

At absolute worst ($V = 0$):

Health check passes if $\text{Deposit} - P \geq 0$.

In this example:

• Deposit = $3,000
• Premium = $1,500
• $3,000 ≥ $1,500 ✓

Key insight: Since premium is NOT included in margin (only in equity), long-only positions can never be liquidated as long as deposit ≥ premium paid. The margin system only tracks option value risk, which naturally goes to zero as the options expire worthless—and at that point, both margin requirement and equity "floor" out together.

Important caveat: If a user's deposit is less than their premium paid, they can be liquidated even with only long positions. The protection only applies when cash covers premium obligations.

Risk Parameters

Mark Price vs Trade Price

The margin system uses mark price (Black-Scholes theoretical) for all calculations, not the trade price:

This prevents manipulation: a user cannot avoid liquidation by submitting fake orders at favorable prices.

Premium Balance Recording

When a trade executes, the actual trade price determines the Premium Balance. For example, if a user buys 10 contracts via RFQ at $51.50 each:

• optionBalance: +10 (long position)
• premiumBalance: -$515.00 (paid $51.50 × 10)

If the current mark price is $50.20:

• Option Value: $50.20 × 10 = $502.00
• Total Position Effect: $502.00 + (-$515.00) = -$13.00

The user paid above theoretical (the spread), so their combined Option Value + Premium Balance shows a small loss.

Integration with Trading

Pre-Trade Check

Before any trade, the system verifies:

1. New position margin: Would the post-trade portfolio be healthy?
2. Sufficient collateral: Does user have enough deposited USDC?

The trade execution updates positions for both buyer and seller, then performs a post-trade margin check to ensure both parties remain healthy. If either fails the margin check, the transaction reverts.

Deposit and Withdrawal

• Deposit: Always allowed (increases equity)
• Withdrawal: Only if post-withdrawal Equity ≥ Initial Margin

Backend Enforcement: These margin checks are enforced both on-chain (contracts revert if post-trade health is violated) and off-chain (backend rejects matches before submission). See Backend Operations for off-chain validation details.

Contract Implementation

The margin system is implemented across several contracts:

Related

Protocol Documentation

• Liquidation — What happens when equity falls below MM
• Options Settlement — Settlement flow using margin

Math Documentation

• Margin Calculations — Mathematical formulas and derivations
• Black-Scholes Model — Pricing used in stress calculations

Contract Documentation

• MarginEngine — Core SPAN-like stress testing library
• DiffusalCollateralVault — Deposit/withdrawal with margin enforcement
• DiffusalLiquidationEngine — Liquidation when MM is breached