Despite scant evidence of a negative impact of speculation in the oil market, in seeking to prohibit excessive speculation and its possible effect on price volatility in futures markets, the US CFTC approved final rules on federal speculative positions limits on commodity futures, options and swaps positions of speculators for 28 commodities in October 2011. As we reported in previous OMRs, position limit rules are being challenged by the International Swaps and Derivatives Association (ISDA) and the Securities Industry and Financial Markets Association (SIFMA) in court. They are challenging the final rule based on whether the Commission overreached its mandate by pre‐emptively setting a position limit on derivatives contracts, amid almost non‐existent cost‐benefit analysis in the final rulemaking, as well as insufficient review of some of the comment letters, which they argue that the Commission was bound to take into account. The court still has to deliver its decision on the speculative position limit rule.
The main hypothesis of proponents of hard position limits is to reduce market share concentration in commodity markets. They argue that doing so ensure that markets are made up of a broad group of market participants with a diversity of views, thereby preventing distortion in market prices. The limit on the concentration of market share is also deemed necessary to reduce systemic risk.
In a latest attempt to reduce price volatility and prevent excessive speculation in oil markets, President Obama asked the US Congress to provide the CFTC with additional authority to raise margin requirements in oil futures markets. However, raising margin requirements in oil futures markets may well lead to an increase in price volatility and concentration of market share of large speculators while having no effect on price levels.
One of the key safeguards in the risk management systems of futures clearing organisations is the requirement that market participants post collateral, known as margin, to guarantee their performance on contract obligations. In contrast to the operation of credit margins in the stock market, a futures margin is not a partial payment for the position being undertaken. Instead, the futures margin is a performance bond that serves as collateral or as a “good faith” deposit given by the trader to the broker. Minimum levels for initial and maintenance margins are set by the exchange. However, futures commission merchants (FCM) have the right to demand higher margins from their customers. The US regulator (CFTC) also has the power to increase margins in emergencies but they have rarely used this option, given the fact that exchanges frequently change margin requirements as a response to a change in volatility and they notify market participants at least one-day in advance.
In a traditional futures market, contracts are margined under a risk-based margining system, which is called SPAN. Portfolio margining systems evaluate positions as a group and determine margin requirements based on the estimates of changes in the value of the portfolio that would occur under assumed changes in market conditions. Margin requirements are set to cover the largest portfolio loss generated by a simulation exercise that includes a range of potential market conditions.
Marked to market ensures that futures contracts always have zero value; hence the clearing house does not face any risk. Marked to market takes place through margin payments. At the inception of the contract, each party pays an initial margin (typically less than 10% of the value of the contract) to a margin account held by its broker. Initial margin may be paid in interest-bearing securities (T-bills) so there is no interest cost. If the futures price rises (falls), the longs have made a paper profit (loss) and the shorts a paper loss (profit). The broker pays losses from and receives any profits into the parties’ margin accounts on the morning following trading. Loss-making parties are required to restore their margin accounts to the required level during the course of the same day by payment of variation margins in cash; margin in excess of the required level may be withdrawn by profit-making parties.
For example, the initial margin for one WTI futures contract is currently $6 885 and the maintenance margin requirement is $5 100 per contract for speculators, 6.5% and 4.8% of the value of the contract as of 1 May, respectively. Initial and maintenance margins for hedgers and clearing members, even for their speculative trading, is the same amount as the maintenance margin levels for speculative traders. However, clearing members’ initial margin for their speculative positions will be increased to that of speculators’ initial margin in early August. Whenever the margin account exceeds or falls below the maintenance margin, the customer receives a margin call from its broker (or broker receives a margin call from the exchange). If the margin account exceeds the maintenance margin, the investor is entitled to withdraw any balance in the margin account in excess of the initial margin and whenever it is below the maintenance level, the customer has to make a deposit to bring the margin account to its initial margin level. The extra funds deposited are known as a variation margin. Basically, if there is a price decline the investor who has a long position has to deposit extra funds, so called variation margin, to bring the margin account to the initial level. On the other hand, the seller of the contract account will be credited. That is to say, if a trader is on the right side of the market, there is nothing to worry about margin calls. However, if a trader is on the wrong side of the market, he/she gets a warning in terms of a margin call to reconsider his/her position.
The Effects of Margin on Market Activity, Composition of Traders, Volatility and Prices
Exchanges argue that changes in margin levels are related to volatility in the markets; if the market becomes more (less) volatile, they increase (reduce) the margin level. The purpose of a change in margins is not to control the composition of traders, volatility or prices but serve primarily as insurance to futures exchanges from default by traders – for example, by setting margin to cover 99% of possible price moves for a position in a trading day.
Some argue that setting higher margins should drive away less risk averse and less informed traders; and without them, markets will be more stable. Others argue that an increase in margin will result in thin markets due to an increase in the cost of using these markets, thereby increasing the volatility. Empirical research generally suggests that the effect of margin on market activity tends to be small as long as margin changes move in line with price volatility. Furthermore, extant research suggests that it is not obvious which types of traders leave the market when margin increases. These studies also find no clear impact of margins on the volatility or price behaviour in the futures markets. It is not surprising to see no relationship between margin levels and the price level, since the latter depends on physical supply and demand.
However, it is important to note that these results are obtained when analysing the impact of relatively small margin changes by exchanges. If we consider raising margin requirements to a very high level through regulations to combat speculation, then we might find that certain trader groups, especially the hedgers and cash-constrained small speculators, will be driven out of the market, increasing concentration share where few traders, especially large traders, participate in the price discovery, leading to more volatile, rather than more stable, oil markets.
IEA Oil Market Report, May 2012
IEA Oil Market Report, May 2012