LME INITIAL MARGINS,
TIME TO REVIEW? The London Metal Exchange has made a reduction in trading fees permanent, after the unpopular fee increase in January 2015 to help recoup the costs of buying the exchange at a multiple of 180x earnings, not a bad sale for a business founded in 1877.
In the interests of boosting volumes, perhaps the LME could review the high levels of LME Initial Margin, especially for spread trades?
Since the global debt collapse of 2008, when some banks were exposed as incapable of pricing or managing their risk exposures, financial regulators have forced banks to give up proprietary trading and massively increase regulatory capital above the previous thresholds of Basle 1 and 2.
Regulators have also pushed OTC products onto Exchange and expanded reporting requirements, increasing market transparency, and replaced the web of bank counterpart credit risk with trades booked at clearing houses.
Margin is the accepted way of reducing counterparty risk but, if margins seem excessive and deter users from the normal business of hedging, then volumes can drop and the market and customers will lose out.
Variation Margin covers negative MTM exposures, and may be applied basis end of day or intra-day, whereas Initial Margin covers the credit exposure due to adverse price moves from the time that a client has failed to post Variation Margin until the position is stopped out, typically 2 or 3 working days.
According to the LME website, the purpose of Initial Margin is “for the Clearing House to be holding sufficient funds on behalf of each Clearing Member to offset any losses incurred between the last payment of margin and the close out of the Clearing Member’s positions should that Clearing Member default”, with the LME using a 2 day liquidation period at a 99% confidence interval.
Most common measures apply historical price volatility and a high confidence level, and can generate surprisingly high risk numbers. LME Initial Margins are dependent on metal and type of position, with outright positions more risky and calendar spreads calculated using the SPAN margining system.
Metal traders know there are different risks to being long or short calendar spreads.
If you’re long a spread, you are exposed to the contango steepening. However, an LME contango can never exceed the full finance (i.e. carry cost of rent, finance and insurance), because riskless arbitrage kills any contango excess over full finance.
If you borrow a spread at full finance, you can only lose on the position if there is a rise in rent, financing costs or insurance during the period (rents are fixed for 12 months), but will fully benefit if the curve moves from contango to backwardation.
However, if you lend a calendar spread you benefit from a steeper contango which is limited to full finance, but you are fully exposed to a backwardation which makes this a much riskier position, especially when lending wider contangos.
IF YOU’RE LONG A SPREAD, YOU ARE EXPOSED TO THE CONTANGO STEEPENING.
16 | ADMISI - The Ghost In The Machine | September/October 2018
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