Margin is the difference between the amount of money a person has to invest and the amount of money they place as collateral. For example, suppose someone purchases $5 billion worth of a security and places $500 million in escrow in an account. That means they have received $4.5 billion in margin. While large amounts of margin can be highly risky, margin can be essential for liquidity. Consider the purchase of a Treasury bill, which is generally considered risk-free. Banks often can receive large amounts of margin to purchase Treasuries since if they ever need to repay that money they’ve borrowed, they can quickly sell the Treasury at face value and recoup the money.
The willingness to offer margin generally depends on two factors: the volatility of the asset and the liquidity of the underlying market. If an asset is highly volatile, margin is much riskier for the lender since there is a chance that the price of the asset falls dramatically and then the borrower cannot repay the loan just by selling the asset. If an asset is in an illiquid market, they may not be able to find a seller who will take face value quickly, which means that the borrower may not be able to come up with cash quickly to repay the loan.
When an asset sees an unexpected increase in volatility, then the lender often will issue a “margin call”, which is when they ask the borrower to post additional collateral.