With recent geopolitical events and natural disasters driving volatility in financial markets, margins – good-faith deposits to guarantee performance on open positions – have spent more time than usual under the limelight.
So we thought it might help to provide a very brief primer on margins as part of this conversation.
At CME Group, we’re intently focused on risk management. As part of our overall risk management program, margins are adjusted frequently across all of our products based on market volatility. When daily price moves become more volatile, we typically raise margins to account for the increased risk. Likewise, when daily price moves become less volatile, margins typically go down because the risk of the position also decreases.
Margins are set as part of the neutral risk management services we provide. They aren’t a means to move a market one way or another, or to encourage or discourage participation from one kind of market participant or another. Rather, margin is one of many risk management tools that help us assess overall portfolio risk to protect market participants and the market as a whole.
There are two main margin philosophies that clearing houses can have. First, a clearing house could set margins sufficiently high to cover all possible volatility environments. Changes are less frequent, but margins are higher. Second, and the CME Clearing approach, is to ensure that margins are set to cover 99 percent of the potential price moves. Margins then are lower in less volatile periods and higher in more volatile periods. Changes are often made when the volatility environment experiences a sustained change.
Who determines margin, and what goes into setting margin levels?
At CME Group, CME Clearing is responsible for setting margins. In doing so, we consider several factors to compute the gains and losses a portfolio would incur under different market conditions. Then we calculate the worst possible loss a portfolio might reasonably incur in a set time (usually one trading day for futures markets).
CME Clearing determines “initial margin,” which is the margin that market participants must pay when they initiate their position with their clearing firm, as well as “maintenance margin,” the level at which market participants must maintain their margin over time. We mark positions to market twice a day to prevent losses from accumulating over time. We typically change margins after a market closes because we have a full view of the market liquidity of that trading day. And, we also provide at least 24 hours notice of margin changes to give market participants time to assess the impact on their position and make arrangements for funding.
In the case of silver, we have made several changes in margin in recent weeks to adjust to volatility in the marketplace. By the close of business Thursday, May 5, the margin when a position is initiated will be $18,900; throughout the life of that trade, we would expect $14,000 in maintenance margin would be kept at the clearing house. By the close of business Monday, May 9, the margin when a position is initiated will be $21,600, and we would expect open positions to keep $16,000 in maintenance margin at the clearing house. This is similar to when you sign up for a checking account – a bank will typically require a minimum initial deposit and can then stipulate that you maintain a certain balance going forward.
It also is important to mention that the way margins are calculated has to be tailored to the market served. For example, portfolio margins for our listed derivatives are based on the CME Standard Portfolio Analysis of Risk (SPAN). CME SPAN is the industry standard for portfolio margins used by more than 50 other global exchanges, clearing organizations, service bureaus and regulatory agencies. Margins for credit default swaps and interest rate swaps are quite different because those markets behave differently and have different kinds of variables that produce risk.
As an industry-leading clearing provider, our risk management methodologies have to work to protect the markets we serve. Our interest is in providing security for the entire market – no matter which way it moves.
We encourage you to bookmark our performance bonds page on our website, or subscribe to our margin change announcements, so you can stay posted on the changes we routinely make to margins.
NOTE: We wanted to make the following paper available to our readers as an additional resource: “Silver and the Margin of Safety.”
Kim Taylor is president of CME Clearing.
Since both Gold and Silver are experiencing huge swings in the market, why are you only increasing the margins on silver?
So now that the silver price has been decimated, margins will decrease, right?
Gen – Thanks for comments and that’s a very good question. It’s important to note that we look at margins across all of our products individually. So, while gold and silver are both precious metals, and it may appear that their margins would be raised or lowered at the same times, they are in fact treated as two very separate products. Therefore, when we look at them we look the risk associated with each product separately. The key factor in what is happening today comes down to volatility. By our analysis and the tools we use we have made several changes to silver to adjust for volatility, which we have continued to see increase. For gold, volatility continues to be covered by current margin levels. And while gold has risen to record prices, we do not adjust margins based on price alone. Hopefully this helps answer your question.
T — that’s not an accurate description of how margins work. As we noted above, margins are set as part of the neutral risk management services we provide. They aren’t a means to move a market one way or another, or to encourage or discourage participation from one kind of market participant or another.
Thanks to all for the feedback on this post. We’ve received a large number of related and similar comments. So rather than respond to each individually, I’d like to make the following points, which will hopefully address much of the feedback.
CME Clearing follows a process in setting margin levels that is geared toward assuring adequate margin coverage is on deposit with financial intermediaries so that market risk may be properly managed.
I want to assure you that our intent is to neutrally consider the facts, and to provide security for the entire market – no matter which way the market is moving. Margin increases impact both long and short position holders. The recent margin increases were necessary due to recent price volatility and large changes in implied volatilities, and our intent was to ensure that appropriate amounts of margin were being held against silver positions.
As far as the process for implementing changes, our margin change notification process is very transparent. Margin changes are distributed at least one day in advance of their implementation. This notification process provides advance notice to allow customers to assess the impact on their position and make arrangements for funding or adjust their position in light of the pending changes. As I am sure you are aware, conditions can change very rapidly in many of our markets.
There are many reasons why people might adjust their positions given increased volatility in the markets – preserving profits, mitigating losses, and adjusting the effectiveness of their hedges are all activities that have a much larger economic impact than the cost of funding adjustments in margins.
Finally, while it was a holiday in the U.K. on April 29 and May 2, our markets were open on both days. Therefore, we felt it appropriate to retain the flexibility to manage our risks, even when other markets are closed.
Again, we appreciate all of the feedback on this post.
Are you denying the fact that your 5 margin increases caused a huge spike in volatility? I believe your 5 margin increases in such a concentrated period of time have made the paper price of silver grossly misleading.
I want to assure you that many of the investing public will learn from this and many will not be fooled any longer.
Ms. Taylor…..when are you going to allow all readers to see the responses made to your article? Your article was written over a month ago. I want to read all the responses to your article. Please make them available at once.
Ken,
I doubt you’ll ever see the responses made to this article, as if they aren’t pro CME Group, they won’t be posted.