Silver prices rose by over 60 per cent between the start of the year and April 25.
They’ve now fallen by over 30 per cent — unwinding some 80 per cent of the upward move in the space of two weeks, according to Société Générale figures. Such violent swings have lead to margin call hikes on the precious metal (along with other commodities) at the Chicago Mercantile Exchange, and have also unleashed a wave of debate about just how much margin moves may have attributed to price falls.
Here’s the CME’s head of clearing, Kim Taylor, explaining margin increases in silver:
Changes to margin requirements are a routine part of market surveillance at CME Clearing, the risk management and compliance unit at CME Group Inc. (CME), which owns Nymex. So far this year, CME has issued over 57 margin change notices.
“I don’t agree that the margin change was a trigger for changes in the market,” said Kim Taylor, president of CME Clearing. Taylor leads a team of sever hundred risk management and compliance professionals who monitor CME’s markets around the clock.
“The market is well tuned so that if there’s a market move that approaches or exceeds our volatility limits” participants know to expect an increase in margin requirements, she said.
The decision to alter trading margins on a contract typically involves risk management professionals involved in day-to-day monitoring of the specific market as well as senior management of the clearing house. The team looks at a variety of quantitative factors like rising volatility and qualitative factors like seasonality and relevant news events in making margin decisions.
“We try to make changes in a way that we can telegraph to the market, so that participants have notice. We try to be routine and predictable and provide no surprises,” Taylor said.
The trading margins are designed to cover around 95% of expected losses, and act as a pre-payment on the coming day’s market move.
“When market conditions become more volatile we would increase margins in anticipation of that, and when volatility decreases we don’t want to create unnecessary capital costs,” Taylor said.
In past instances, CME Clearing has often raised trading margins ahead of certain events in an attempt to damp their impact on trading. For example, the exchange-operator increased trading margins on several products, including crude oil, ahead of Hurricane Katrina to ensure traders were prepared for higher volatility .
“We try to be proactive with either something we can measure or something we can judge to likely effect our markets,”
And here’s the Streetwise Professor with a takedown:
The changes that CME made, and which Kim explains, are sensible in a microprudential sense. They help ensure that the CME has a sufficient buffer to absorb defaults by traders. CCPs try to work on the “loser pays” model, and with more volatility, there are bigger losers–so margins have to be higher to ensure they can pay.
But the implicit assumption here is there isn’t feedback between margins and prices. Indeed, that’s the gravamen of Taylor’s argument (“I don’t agree that the margin change was a trigger for changes in the market”). That is the essence of a microprudential approach. That assumption, however, is quite tenuous, and almost certainly untrue. This is particularly the case for big margin changes during unsettled market conditions.
That is, when setting margins, CCPs (and participants in bilateral markets too) typically act as if they are price (and volatility) takers, when in fact they are big enough and their decisions are material enough to be price and volatility makers. Acting microprudentially, they typically fail to take into account the feedback between their decisions and market prices, or at least do not do so completely.
The feedback mechanism works because frequently market participants will respond to margin changes by liquidating positions. Those who have already lost money as a result of big price moves are the most likely to liquidate, which tends to exacerbate the original moves. That’s one reason why you can see bigger than expected moves (as occurred in oil last week) to fundamental shocks.
This is why CCP policies that are prudent in some sense can be macroprudentially dangerous. Silver, and perhaps oil and other commodities, may be providing an object lesson of what is in store when clearing is extended to vast new markets. When OTC clearing mandates kick in, the scope for these destabilizing feedbacks will expand dramatically.
As the professor points out, upcoming financial reform codifies this kind of margin call behaviour — and even ups the ante with an established confidence level of 99 per cent. The reasoning of course, is that the central counterparties need enough of a capital cushion to withstand violent market movements and make good on their mandate as enhancers of financial stability. Unfortunately it seems regulators may have been caught between creating thinly-capitalised but ‘market friendly’ CCPs, or ‘risk-free’ margin-intensive counterparties that could cause market consternation through reflexivity.
On that note, it’s also interesting to watch the same financial reformers now scurrying to distance themselves from the new clearing rules.
Related links:
Step away from the CCP - Deus Ex Macchiato
On clearing house concentration risk – FT Alphaville
The case of central clearing - John Gregory, via Scribd
Clearing house swap downs – FT Alphaville