A Not-So-Marginal Risk in Silver

By EconMatters

Our research analyst John Gray was interviewed by Carolyn Cui from Wall Street Journal regarding why we believe CME should have raised margins on silver earlier and had missed the best opportunity to do so.

Below are excerpted from Carolyn's article--Tripped Up by the Margin--dated June 8, 2011 along with some more of our thoughts:

Commodity investors have long been used to wild market swings driven by wars and hurricanes. But recently a new risk has been added to their list: margin requirements.

Investors are still crying foul over CME Group Inc.'s decision to raise margins five times over just eight trading days. Between April 25 and May 5, the exchange operator increased silver margins to as much as 12%, or $21,600 per contract, from 6%. Silver tumbled 25%.?

Chart Source: WSJ.com

The lack of disclosure riles John Gray, a researcher at EconMatters.com, a website dedicated to economic and market analysis.

"They need to be more transparent," Mr. Gray said, adding that margins should be a consistent percentage of the contract price, and that exchanges should give more warning of any moves.

Mr. Gray is among market participants who say the CME should have raised silver margins earlier. CME increased once in March, but didn't make any changes until a month later. Silver prices gained about 30% to $47.151 an ounce between those moves.

"It should have been a red flag to CME when silver crossed the $40 threshold that they needed to raise margins significantly," Mr. Gray said.

EconMatters additional comment:

Compounding the problem is that brokers also raised their in-house margins on top of the ones CME implemented. Carolyn's article noted Interactive Brokers "overstepped the exchange twice" in hiking silver margins, while MF Global is another broker, had also charged more margins on silver than what was required by exchanges at the time. That set off a mass liquidation spilled over even to the other asset classes as well with investors scrambling to cover the newly raised margin requirements.

Ideally, margin requirement should be set by the criteria the Exchange deems proper based on experience and historical pattern, and preferably at a fixed percentage at all time, instead of jumping all over the place as illustrated in the chart above. So as the price of the underlying commodity goes up or down, a consistent percentage of margin requirements is maintained--i.e. more real-time mark-to-market.

This will help reduce market volatility as traders won't be caught off guard and be forced to liquidate large positions in order to meet the sudden raised margin requirements. A fixed percentage also will increase the transparency while keeping the risk of over-leverage in check.

Note - Carolyn's full article is available here at WSJ.com.