We have seen a lot of interest lately from clients in China-based markets, in particular for commodities. But whilst the contracts are standard futures and options, the margin calculation is very different from that used by other CCPs.
At present, margin for the majority of ETD contracts is calculated using SPAN, although a number of markets are now looking to move to VaR-based algorithms. But the Chinese market requires a completely different solution to support the calculation of requirements.
So how is margin calculated for the Chinese exchanges and how does it differ from that used on other markets?
The key markets that clients are asking about are Shanghai Futures Exchange (SHFE), Shanghai International Energy Exchange (INE), Dalian Commodity Exchange (DCE) and Zhengzhou Commodity Exchange (ZCE).
These exchanges are all focused on the commodity sector. The Shanghai markets cover a range of metal and oil products. Dalian trades similar products as well as agricultural contracts, while Shengzhou focuses on agricultural products as well as other commodities including glass.
How is margin calculated?
All of the CCPs for the exchanges listed above use basically the same methodology for calculating margin, with some variations dependent on the product.
The methodology is based on a margin rate set as a percentage of the price. This rate is increased as contracts move closer to expiry. There are also other factors that can affect the margin requirement:
- Different rates can be applied for long and short positions.
- For some products, multipliers are used for speculator accounts.
- Arbitrage (spread) margin can apply for some offsetting expiries – although a minimum margin level applies so these are limited.
The margin rates that apply are generally fixed by regulation. However, if prices move sufficiently then the percentages can be adjusted to reflect the increased potential losses.
The collateral used can also affect the margin requirements. In particular, warrants can be used to cover short positions as they approach delivery, with the exact timing dependent on the product.
How does this compare with other markets?
The margin methodology applied to Chinese markets is very similar to those used before scenario-based methodologies such as SPAN were introduced. There are a number of ways in which the calculation differs from that most firms are used to on cleared ETD markets:
The savings applied to offsetting positions are limited. For some products spreads are available between expiries but these are subject to a minimum margin. This compares with SPAN where the Scanning Loss assumes offsets between all expiries, although this is adjusted by a spread charge (intra-commodity charge). SPAN also allows offsets between correlated products. The VaR methodology used by some CCPs inherently includes offsets both within and between contracts.
Warrants are available as collateral on some non-Chinese markets, for example LME. Although these tend to be accepted for both long and short positions and for any expiry, where they are allowed as collateral then a haircut will be applied. The Chinese market considers them more directly as a substitute for the position that is to be delivered.
The margin rate applied in the Chinese market can be quite significant for contracts during the delivery period. These are generally higher than the rates set for SPAN or the level implied by VaR, although both methodologies do tend to vary the margin calculated depending on the expiry. In particular, for both of them the requirements tend to be higher for more volatile front months. SPAN also has the concept of Spot Margin which can increase the requirement for a specific expiry.
These higher rates used in the Chinese market are also an alternative to delivery margin. They are not as specific to the risks as those calculated by some other CCPs, for example those that require full value as margin against the risk on on-delivery.
In the short term the way in which margin requirements are calculated for the Chinese market is unlikely to change. Therefore it is necessary to understand the current methodology in order to replicate the margin to support use cases such as validation or what-if.
In the future it is likely that the Chinese CCPs will miss out the step of updating to use scenario based algorithms, and instead move straight to VaR-based methodologies. This is a future complexity which must be considered when looking at solutions to support the Chinese markets.