Transactions in futures involve two counterparties, the buyer and the seller. Every counterparty has to put aside the margin, an amount to serve as a collateral deposit in the event that she cannot meet its obligations stemming from the futures contract agreement. Until recently, futures exchanges had the authority to set and change margin levels in commodity futures markets. Doing so, they have been using margins as a risk management tool to eliminate credit risk. However, the 2003-2008 spectacular increase in commodity prices across the board of commodities (energy, metals, agricultural, livestock), termed commodity boom, has revived a longstanding debate. Should commodity futures margin requirements be regulated by a supervisory body or should they be determined by the exchange where the respective futures trade? This debate was ignited by a number of U.S. senators who argued that speculators have driven commodity prices up, thus threatening public welfare. Hence, they urged President Obama to command authorities to increase commodity futures margins to push speculators out of the market. As a response, the 2010 Dodd–Frank Wall Street Reform and Consumer Protection Act gave the authority to the U.S. Commodity Futures Trading Commission (CFTC) to establish margin requirements. Doing so, margins could also be used as a policy tool. So far, CFTC has not exercised this authority, yet the view that it should do so gains popularity.1, 2
Proponents of futures margins regulation argue that regulation will put away the “bad” speculators who increase commodity prices. This can be done because a margin increase will reduce speculators funding ability and force them to close their positions. This will decrease asset prices as a result. Those against regulation take a different view, namely that regulation may decrease market liquidity since margin increases may drive “good” speculators who provide liquidity out of the market. These pros and cons of margin regulation are formalized in the seminal paper by Brunnermeier and Pedersen (2009). In addition, an increase in margins may even harm social welfare because it may impair the risk-sharing role of the futures markets. One of the primary roles for a futures market is that it allows hedgers transfer their risk to speculators by compensating them by a positive risk premium. However, an increase in futures margins may also affect hedgers on top of affecting speculators. This is because hedgers either they may not afford hedging costs incurred by the margin change (Telser, 1981) or they may not find speculators to hedge their risk. Last but not least, margin regulation could lead to high margins which would discourage investors participating in the market and hence the futures exchange will lose part of its clientele.
In light of the recent debate on whether commodity futures margins should be regulated, we assess the effects of margin changes on commodity prices, the risk-sharing between speculators and hedgers, and the price stability of commodity futures markets (Daskalaki and Skiadopoulos, 2014). As is the case with many polarising debates, there is truth in both perspectives.
First, we found that margin increases do not decrease commodity prices as commonly believed but they do act as a ‘brake’ on the rate at which prices increase. Second, we also found that while regulation of margins will likely constrain excessive speculation, such measures may also impair significantly market liquidity and the risk sharing function by forcing hedgers out of the market. Third, our findings, which involved a detailed examination of 20 discrete commodity futures markets, suggest that if a regulator is to introduce controls on margins, then the individual characteristics and features of each market sector must be considered. For instance, the effect of margin changes on the risk-sharing mechanism of the energy market differs from the margin changes effect on that of the agricultural or metal markets.
Finally, margin increases may have irreversible consequences which will also diffuse across commodity markets. Once margins are increased, a margin decrease of the same magnitude will not restore the market to its previous state. In addition, we find that margin changes for futures written on a specific type of commodity (say energy) will also affect the features of futures written on the other commodity categories (say metals). This can be attributed to the fact the commodity traders take positions in various commodity markets. Hence, when they liquidate positions in one commodity market, they move to other commodity markets.
We confirm that commodity futures margins regulation has pros and cons. Policymakers should take into account the fact that the effect of margin changes varies across commodity groups and they should be very cautious before implementing any margin changes because the consequences may be irreversible. Our findings are in line with Alan Greenspan’s (1996), former Chairman of the Federal Reserve, contention: “I guarantee you that if you want to get rid of the bubble, whatever it is, that [raising margin requirements] will do it. My concern is that I am not sure what else it will do”.
Brunnermeier, M.K., and Pedersen, L.H., (2009). Market liquidity and funding liquidity. Review of Financial Studies 22, 2201-2238.
Daskalaki, C. and Skiadopoulos, G. (2014). The effects of margin changes on commodity futures markets, Working Paper, Queen Mary University of London.
Greenspan, A. (1996). Minutes of the Meeting of the Federal Open Market Committee, September 24, 1996, Page 31.
Telser, L.G., (1981). Margins and futures contracts. Journal of Futures Markets 1, 225-253.
1. “…Government data confirm that oil speculators are driving the price increase …In the Dodd-Frank Wall Street Reform and Consumer Protection Act, we empowered your Commission with a number of new tools to rein in excessive speculation and prevent market failures … Now is the time to exercise that authority…. Higher margin levels would reduce incentives for excessive speculation by requiring investors to back their bets with real capital…”
U.S. Senators letter sent to Gary Gensler, chairman of the Commodity Futures Trading Commission (CFTC), March 2011.
2. “…Mr. President, if CFTC Chairman Gary Gensler doesn’t act soon to implement rules that will cut down on speculation in the oil futures markets, then you should consider not reappointing him.”
Senator Nelson, in his letter to President Obama, April 2012