A difficult year for margin

Jo Burnham
Risk & Margining SME at Opengamma

2020 was not a good year. Except if market volatility is your thing, in which case it was a very good year. Obviously the main cause of the volatility was the COVID-19 pandemic, but there was also the small matter of a contentious US election, a dispute between Russia and Saudi Arabia over oil and the continuing saga of Brexit, all of which have had an impact on the markets.

It doesn’t look as though 2021 is going to be any less volatile. COVID is still with us and it will take a while for the impact of any vaccines to be felt. The pandemic has also left its mark on economies so expect the market to continue to react to news of recoveries, or not as the case may be.

This volatility has had an impact on margins with rate changes happening, at times, on a near daily basis. The jump in requirements has resulted in procyclicality – increases in margin causing more volatility in the market. All of this has meant squeezes on liquidity, making it more important than ever that firms are managing their margin effectively.

Quarter 1

The year actually started quite normally, with COVID just something that concerned China or cruise ships. Everyone expected the big talking stories to be Brexit (although that was a deal that was supposed to be ready to go) and the US election. 

Then in early March, a stand-off between Russia and Saudi Arabia came together with the spread of COVID across Europe, resulting in a 30% collapse in the oil price. 

Because of the increase in cases, countries across the world started introducing lockdowns, leading to falls in the use of oil.

Worries about global storage capacity becoming full because of the reduction in demand meant that oil firms resorted to renting tankers to store the surplus supply, causing WTI prices to turn negative.

Initial margin requirements climbed within days, with increases of up to 21% (equivalent to more than $13,000 per lot on Brent contracts).

There were multiple intraday margin calls, impacting long position holders, and the extreme price moves ultimately led to increases in initial margin, impacting all position holders. Margin parameters usually change around once every 3 months, but in this period oil margins were changing once every 3 days. These rapid changes created heightened industry-wide concern over the possibility of unexpectedly large future margin calls Equity markets were equally volatile. The E-mini S&P 500 margin requirement began the year at $6,300 per contract and by March 2 it had risen to $6,600.

Then the pandemic hit, and over the next three weeks CME increased the initial margin requirement six times. By March 23, the initial margin requirement had been raised to $12,000 per contract, nearly double the amount at the beginning of the year.

Similarly, initial margin requirements for the Eurostoxx 50 futures went from 2,700 Euros per contract to more than 5,600 Euros between the 10th March and the 15th April, more than doubling in just over a month.

In Asia, Nikkei 225 futures saw a similar increase in requirements. JSCC increased the margin rate six times in March, raising it from 720,000 Yen on the 2nd March to 1.62 million Yen by the 30th March. 

Although oil and stock prices were the first to react to the oncoming pandemic, there was a similarly big impact on the bond market. During the week of 9th March, firms began selling US treasuries in an attempt to generate cash. However, there were few buyers so prices started to move rapidly, with not all parts of the market moving at the same pace.

Bond prices started to diverge from futures prices. Hedge funds with cash/futures basis trades started hitting stop-loss limits, beginning an unwind of these positions. By 15th March, the US Federal Reserve was forced to step in, promising to purchase US Treasuries in order to stabilise the market.

By the end of the month, the margin was $1,850, an increase of 61%.

On Eurex, the increase in Bund margins was even larger. It rose gradually from 2,212 euros per contract at the start of the year to 2,303 euros per contract at the beginning of March. It then rose extremely rapidly, ending the month at 4,323 euros per contract, an increase of 88% over just four weeks.

As with the other bond futures, the initial margin requirement on JGB futures rose very rapidly during February and March, moving from 510,000 Yen on 21st February to 1,230,000 yen by 23rd March, an increase of 141% over four weeks

This market volatility in the first quarter of the year had a direct impact on overall margin requirements, and not just initial margin rates. Looking at the disclosures that the CCPs provide, over the first quarter of the year the total peak variation margin call across all CCPs was double any previous maximum seen.

Quarter 2

The lockdowns around the world continued to have an impact on markets. Global demand for energy plummeted, with the International Energy Agency (IEA) forecasting a 6% drop in energy demand for the year.

At points, the decline in energy demand was the largest drop since the 1930s Great Depression, with weekday electricity consumption equivalent to normal Sundays.

The impact was global. Electricity prices in Japan were effectively zero on an increasingly regular basis as the coronavirus pandemic slowed industrial activity, whilst renewable energy supplies such as solar increased over the summer period. 

This fall in demand, helped by the restrictions on travel and business, led to unprecedented drops in carbon dioxide emissions, larger than the fall in 2009 which followed the financial crash, with emissions at their lowest level in a decade.

Over this period, markets in Asia continued to show significant changes in margin. On the Nikkei, there were six reductions in parameters and by the beginning of June the initial margin requirement was back under the one million mark. 

For the JGB, unlike the other bond futures, the initial margin requirements continued to be highly volatile.

Over a period of nine weeks parameters changed six times, bringing the level down to 600,000 Yen, but then it abruptly jumped back up to 930,000 Yen on 26th May.

Quarter 3

As countries came out of lockdown, relative normality returned to the markets. The CCPs reintroduced delayed initiatives, such as the change of the discount rates of its euro interest rate swaps from Eonia to €STR.

The equity markets were influenced by the ill-natured US election campaign and the ongoing Brexit negotiations. The return to work coincided with a general recovery, although there were some casualties, notably in hospitality and retail. There was also some profit taking, but no real margin rate changes.

However, in September a second wave of infections caused something of a setback, with those countries most impacted seeing the highest volatility.  However, this had little impact on margin levels as the volatility earlier in the year had already been taken into account in parameter setting.

Quarter 4

However, by the end of the year the majority of global indices were higher than at the start of the year, with the tech heavy Nasdaq showing the biggest gains at around 42%.

The end of the year was originally dominated by the US election. In October, the possibility of a Democratic win led to support for stocks exposed to energy efficiency and renewables given Biden’s green agenda.

Immediately after the vote, with the result looking too close to call, the Dow closed up more than 1.3%, while the wider S&P 500 climbed 2.2%. The tech-heavy Nasdaq gained nearly 3.9%. The markets believed that a divided government would result in less sweeping legislative, spending or tax changes, and therefore reduced uncertainty.

However, it was the announcement of the first successful vaccine against COVID-19 less than a week later that had the biggest impact on the markets. Pfizer’s shares climbed 9% when they said that preliminary analysis showed their vaccine to be 90% effective. The FTSE 100 was up nearly 5%. The Dow Jones started up 5.6%, but that initial optimism faded and it ended the day up just 3%, while similar moves on the S&P 500 meant that it ended up 1.1%.  And the Nasdaq actually fell 1.5%, because of the dependence on the tech firms that have made the most out of the many lockdowns. 

The markets were further spooked by the increasing infections in the UK and the discovery of a new mutation of COVID-19 that was more transmissible.

The UK FTSE, however, finished 14% down on the year, mainly because of the predominance of travel and retail companies most impacted by the pandemic. Again though, it was the price moves and resultant variation margin that impacted margin requirements. Changes in initial margin have tended to generally be down, and at a much less dramatic pace. The E-mini S&P 500 is now at $11,000, very little change from its peak. The ICE Brent margin, however, is now at levels last seen at the beginning of March.

How margin added to the volatility

All this increase in market volatility, and the subsequent increase in initial margin, particularly during the first half of 2020, has brought the issue of procyclicality to the forefront. Looking at the disclosures provided by the CCPs, total initial margin rose by nearly 50% during the first quarter. This led to huge increases in the amounts of collateral posted to clearing accounts.

This extreme market volatility necessitated an extraordinary number of intraday margin calls, particularly in March. These calls contributed to the overall stress levels in the markets, in many areas creating further volatility. 

The rapid increases in margin requirements created funding issues for both clearing firms and their clients. It became even more difficult for firms to predict their liquidity requirements, made worse by the fact that many of these intraday calls were unscheduled, based on price levels being breached rather than occurring at specific times of the day

It isn’t surprising that CCPs make intraday margin calls. Margin parameters are set to cover a certain confidence level and it is inevitable that in times of increased volatility these will be breached. Additional funds will be required to cover potential variation margin losses. However, regulation determines that the CCPs should have a buffer in their margin rates such that in the sorts of markets that we have seen over 2020, it is not necessary to raise requirements to cover the increased potential losses, and hence not add to the stress in the market. Given the number of margin increases that have been seen, it is likely that the CCPs didn’t always remember this.

In March, Ronin Capital failed to meet a margin call from their clearer, ABN Amro, based on their short position in Vix contracts cleared at OCC. Rather than immediately calling them into default, ABN allowed them to trade out their positions. This action drained their capital, bringing them below the level required by CME, where they were a direct clearing member. CME decided that they had no choice but to close out the Ronin positions via an auction, and what was once the largest proprietary trading firm in Chicago has now closed.The unprecedented slump in fuel demand and drop in oil prices led to huge losses at Hin Leong, one of the largest fuel traders in Asia and an operator of a major tanker fleet. The company filed for bankruptcy in April with losses of $3.85bn, with their founder O.K. Lim admitting to personally hiding $800m in losses on oil futures.

What Happens Now?

2021 hasn’t started too well, and it is likely that volatility will still dominate the markets. Which means that there will continue to be liquidity issues related to margin. Going forward it’s going to be key for firms to be able to manage their margin efficiently; choosing where and what they clear in order to optimise margin, having the ability to predict requirements in order to minimise liquidity buffers and validating margin calls to ensure that mistakes are not being made in an attempt to keep up with the fast moving markets.

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