Commodity margins: art,sc,politics?

CME says not a black box,a judgment call

Experts ponder political risks,price impact

The CME,which operates the world8217;s leading energy,grain and precious metal markets,portrayed a series of five increases in silver margins,and this week8217;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.

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 it8217;s a judgment call.

It8217;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 8212; 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 exchange8217;s risk models and algorithms then that8217;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.

There8217;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 agency8217;s plan to impose position limits within weeks.

It8217;s a huge concern,Senator Carl Levin,who heads a new presidential panel investigating oil market manipulation,said on Tuesday of volatility in commodities.

SILVER SCALE MODEL?

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 silver8217;s 25 percent nosedive last week to the CME8217;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.

The CME raised silver margin requirements four or five times in a dramatic and draconian fashion. Whenever that happens,there is a big correction,commodities guru Jim Rogers told Reuters Insider in an interview on Tuesday.

Meanwhile,the potential for short-term volatility caused by uncertainty over margins is real,experts argue.

The stakes are set to rise massively as regulators force more of the 600 billion global over-the-counter derivatives market through clearing houses.

Think of silver as being a scale model of what could happen when OTC swaps are cleared in a big way,says Craig Pirrong,a finance professor and regulatory expert at the University of Houston who argues that margins affect prices.

Changes in initial and maintenance margins adopted in response to big price moves can destabilize things. he wrote this week on his blog streetwiseprofessor.com. Smaller markets can recover quickly. But for bigger markets like the OTC swaps,it may rattle them by more than they can withstand.

THE MAN AND THE MODEL

In their simplest form,margins are cut and dried: they are the prepayment of potential losses,explains Taylor,cash deposits paid by investors to a clearing house to cover the risk of default. They are meant to cover either 95 or 99 percent of all anticipated losses,depending on the market.

Unlike equity markets,where margins are dictated by the Federal Reserve and used more or less explicitly to limit speculation and thus prices,commodity markets establish their own,having successfully argued against repeated efforts to impose more government controls over the past century.

In that period it has an unblemished record,having never experienced a default. The margin-call model also helped exchanges emerge largely unscathed from the Lehman Brothers debacle and ensuing financial crisis.

The CME has 35 to 40 risk professionals in Chicago,New York and London monitoring markets around the clock. If any of them see unusual volatility,they can set the wheels in motion for a possible adjustment in the margin,Taylor said.

The CME Clearing management team would approve those changes,usually after a market closes.

The two most basic metrics for assessing volatility are fairly clear and understood: the actual volatility in futures prices; and implied volatility derived from options trade.

But the team can also look at other less quantitative market conditions,including news or macro-economic events. It can even hike margins ahead of events,as it did when Hurricane Katrina was bearing down on the U.S. oil patch in 2005.

Taylor said her team would take note of the total number of speculators in the market,but that figure wasn8217;t as important as the potential risk of concentrating too much of the market with a single counterparty.

The type of market player doesn8217;t matter as much as the diversity of market players,she added.

The CME can then test the extent to which a margin increase or cut would cover anticipated losses using the Standard Portfolio Analysis of Risk SPAN quantitative model. Developed by the exchange in 1988,it has become the industry standard used by some 50 exchanges globally.

The degree of discretion can be plain to see.

The New York Mercantile Exchange quickly raised its benchmark U.S. crude oil contract margins in response to last week8217;s abrupt and unexpected fall that caused volatility to spike. It did not boost margins following a similar pick-up in volatility last May,amid heightened European debt concerns.

It also waited until two days after the big fall to raise crude markets; on Wednesday,it hiked gasoline margins by 21 percent on the same afternoon that price fell limit down.

The CME also administers margins differently than arch-rival IntercontinentalExchange and its Brent crude contract. The CME has raised WTI margins four times for a cumulative 67 percent increase since February,while the ICE has raised margins 9 times totaling 47 percent. Its latest rise on Wednesday increased margins by just 9 percent.

While a record gap has emerged in the prices of WTI and Brent,their volatility remains similar.

ICE seems to be far more model-driven than the CME,says Dennis Gartman,a long-time commodity trader who also sits on the board that makes decisions on margin changes at the Kansas City Board of Trade.

POLITICAL RISK

The last time margins became a political issue was following the stock market crash of 1987,when rumors about the integrity of the clearing houses caused a surge in calls. The presidential Brady Commission that investigated the crash recommended that margins be set equivalent in futures and stocks,and that both be regulated by the Federal Reserve.

The CFTC demurred,arguing that margins too high would diminish liquidity and undermine the market8217;s function. It allowed exchanges to continue setting their own margins,although it retained the right to set temporary margins in the event of an emergency,part of the Commodity Exchange Act.

The CFTC is usually informed of margin changes as a courtesy,but not always,Chairman Gary Gensler said on Wednesday. He said there is close dialogue on levels and the CFTC does its own modelling and stress-testing.

But while the Dodd-Frank regulations gave the CFTC more authority to write policy and procedure rules,he said,the responsibility is clearly the clearinghouse8217;s.

Still,some say Washington8217;s role is substantial.

David Greenberg,a member of the NYMEX board from 2000 to 2007 and founder of one of the biggest local clearing houses on the now CME-owned NYMEX,put it bluntly: It was window dressing to get the government off their back after the recent remarks by President Obama and Attorney General Holder.