Tripped Up by the Margin

The crisis we had in 2008 was driven by leverage that investment banks like Goldman Sacs were able to get as a percentage of the capital they had on their balance sheets when compared to a FDIC backed bank. Following the crisis and the bail out investment banks were forced to reduce the leverage they could apply on capital to the levels of banks backed by the FDIC. Reduction of leverage reduces the crazy bets that can be made with other peoples money.

Aivars Lode


Tripped Up by the Margin

Text By CAROLYN CUI
Commodity investors have long been used to wild market swings driven by wars and hurricanes. But recently a new risk has been added to their list: margin requirements.

Margins, the amount of collateral investors must post against their trades, are designed to help reduce the risk to exchanges and calm overheated markets.

But recently that safety valve is being blamed by some for wreaking havoc on markets such as silver, gasoline and cotton. As prices swung wildly, major commodity exchanges ratcheted up their demands for collateral, setting off a chain reaction that forced many investors to liquidate their holdings, sending prices tumbling.

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."Whenever the margins are reacting to conditions, such as higher volatility, they can essentially exacerbate the impact of those conditions," said Craig Pirrong, a finance professor at the Bauer College of Business, University of Houston. "It tends to reinforce the initial shock."

Silver's tumultuous ride in late April is a case in point, Mr. Pirrong said. Investors are still crying foul over CME Group Inc.'s decision to raise margins five times over just eight trading days. Between April 25 and May 5, the exchange operator increased silver margins to as much as 12%, or $21,600 per contract, from 6%. Silver tumbled 25%.

"There's no way that the market could handle it," said Neal Greenberg, a silver trader in New Jersey. "Silver was on the ledge. CME basically shackled its legs with cement blocks and pushed."

In early May, CME also raised margins on gasoline by 48%. Gasoline prices then dropped as much as 15%. In mid-February, as prices of cotton rose toward $2 a pound, ICE Futures U.S. boosted its margin by 50%. Prices fell 5% the next day.

Exchanges, Mr. Pirrong said, "should at least have some sort of recognition" of the impact.

"We do consider the timing and the notice, trying to make sure the market will have the time to absorb the changes and be able to arrange the funding," said Kim Taylor, president of CME Clearing. She said the exchange focuses on price volatility, rather than direction.

Margin moves have "a small order effect" compared with other influences, she said.

Some traders say current margin levels are equally puzzling. Margins for silver, cotton and gasoline remain unchanged from their peaks, despite a big drop in volatility.

Commodities investors are particularly sensitive to changes in margin requirements. One of the biggest attractions of the commodities markets is their combination of high volatility and low margins—usually 5% to 8% of the underlying contract's value—allowing them to generate outsize profits with limited amount of capital. Stock trading typically requires 20%.

That presents a dilemma for exchanges, said Thomas Peterffy, chief executive of Interactive Brokers LLC. They want small margins to encourage trading, but they need to protect against the collapse of a trader or broker.

For most in the market, the process of setting margins is couched in mystery, making it hard to predict whether, or when, they may be raised or lowered.

The CME has a group of 15 to 20 risk managers in Chicago, New York and London who monitor a variety of factors such as intraday price moves and other volatility measures. They also take into account other market-moving events, such as a pending storm or political turmoil, Ms. Taylor said. Changes usually take effect a day after being announced.

ICE Futures, a commodity exchange owned by IntercontinentalExchange Inc., says it looks at a set of nine factors when determining margins. A spokesman declined to specify all the factors, though adding that they include the size of the daily move relative to recent days, along with "other observable price and statistical triggers."

The lack of disclosure riles John Gray, a researcher at EconMatters.com, a website dedicated to economic and market analysis.

"They need to be more transparent," Mr. Gray said, adding that margins should be a consistent percentage of the contract price, and that exchanges should give more warning of any moves.

Still, some say the current system works. If the exchange gives out details, traders can "game the system," said Todd Petzel, a former chief economist at CME Group.

Mr. Gray is among market participants who say the CME should have raised silver margins earlier. CME increased once in March, but didn't make any changes until a month later. Silver prices gained about 30% to $47.151 an ounce between those moves.

"It should have been a red flag to CME when silver crossed the $40 threshold that they needed to raise margins significantly," Mr. Gray said.

Other exchanges say their systems didn't pick up extraordinary volatility during silver's run up.

"The initial stage of that rally was relatively orderly," said Tom Callahan, chief executive of NYSE Liffe U.S., a competitor to CME, which started to raise margins on its silver contracts on April 27.

Brokers say they were well ahead of exchanges in taking action on margins.

Interactive Brokers in Greenwich, Conn., "overstepped the exchange twice" in hiking silver margins, Mr. Peterffy said. "It's too late to come in when prices are high," he said.

MF Global, another broker, had also charged more margins on silver than what was required by exchanges at the time, traders say. MF Global declined to comment.

—Liam Pleven contributed to this article.
Write to Carolyn Cui at carolyn.cui@wsj.com