NEW YORK (Reuters) - Recent nerve-shattering hikes in the amount of money exchanges require to trade commodities have stoked concerns over an often overlooked cornerstone of managing risk in futures markets: setting effective margins.
The CME (CME.O), which operates the world’s leading energy, grain and precious metal markets, portrayed a series of five increases in silver margins, and this week’s 25 percent rise in escrow requirements for oil, as prudent responses to unusual volatility as prices surged to historic levels, then swooned.
But a close examination of the relationship between price volatility and margins, and of ways exchanges apply margins to similar products, shows these decisions are not automatic. And as the past three weeks have shown, decisions whether or not to change them can become the subject of intense speculation.
While the CME says its policies are largely predictable, mitigating the chances of them triggering anything like the crash in silver prices, they also say it’s a judgment call.
“It’s not a science, not a black box. Judgment and experience definitely come into play,” Kim Taylor, President of CME Clearing, told Reuters this week. With some 40 experts monitoring both realized and implied volatility around the clock, “we have flexibility around the margin levels.”
After last week, some wonder whether the exchange was factoring a new variable into its considerations — political risk or, at its most extreme, political interference.
Taylor dismisses the suggestion that anything other than market factors are used to set margins, a critical task that safeguards the ability of an exchange to keep functioning in the event that one of its members fails to pay up.
But some industry experts and traders say it would be logical for exchange executives to take a more proactive approach to managing systemic risk. With high food and fuel prices topping political agendas, exchanges would be wise to head off potential criticism that they stood by while markets got overcooked and then melted down.
If this was a change dictated by the exchange’s risk models and algorithms then “that’s fine,” said Jerry W. Markham, a professor of law at the Florida International University at Miami and an expert on commodity market regulation.
“But these changes were large enough and rampant enough that it looks like to me, sitting outside the process, they may have been designed to discourage speculation.”
There’s no question pressure from Washington is growing.
A group of 17 U.S. senators on Wednesday called on the Commodity Futures Trading Commission to crack down immediately on excessive speculation in crude oil markets, demanding the agency’s plan to impose position limits within weeks.
“The wild fluctuation could only be the result of rampant oil speculation, plain and simple,” said Senator Ron Wyden, one of the lawmakers who wrote to the CFTC demanding action.
Free from regulation, exchanges must walk a tightrope in setting margins high enough to protect themselves from default, but not so high that they choke off liquidity and trading volume, their primary source of revenue. Futures commission merchants also set their own margins for customers.
Many traders tied silver’s 25 percent nosedive last week to the CME’s 84 percent increase in silver trading margins over two weeks. Yet such a massive collapse resulting from an increase in margin is rare if not unprecedented.
CME officials say margin adjustments do not move prices very much. Typically, market reaction is transitory and brief.
But a sharp increase in trading costs will often force many smaller speculators to close positions rather than pay up to maintain them. As a result, prices can fall, at least briefly. Market talk of a margin call by a major brokerage, though not an exchange, was mooted on Wednesday as a possible cause for the second sharp fall in commodity prices in a week.