Monday, March 16, 2020

Market stress - Margin plumbing matters


Two critical issues that drive the plumbing of financial markets are financing rates and margin. By lowering the short rate by 50 bps on March 3rd and 100 bps on March 15th, the Fed is attempting to relieve financing pressures, but what may be as critical an issue is the margin and collateral necessary for levered trades. Rates may be headed lower, but margins are moving higher. 

A close look at the changes in initial and maintenance margin shows significant increases from the CME clearinghouse. For example, after the close of business on March 9th, the bond contract saw initial margin go up by over 20%. The next day SPX stock index contract margin increased 10%. Overall, there were increases across the board in almost all markets. Margins do not fully reflect the increase in short-term volatility which by its nature will cause position cutting and more money flows out of margin accounts.  

Notably, clearing firms may be raising margins even higher. While this may not be a critical issue for hedge accounts, it is a problem for speculative accounts especially for relative value hedge funds. Cash has to be raised in trading accounts when margins.

The impact of margins increases has been studied by a number of researchers. The findings are mixed. It cannot be said with certainty whether prices will rise or fall on a margin increase, but we can conclude that there will be an increase in volatility and a decline in liquidity 

When margins are increased by the CME, there is a corresponding increase in clearing firm margins. Clearing firms may further increase margins to have excess cash cushions. Money will have to be moved into accounts especially for traders who are wrong-sided. Marginal positions will be closed. Margin increases are a natural response to higher volatility, but there will be a further shake-out that will spill-over to overall liquidity. Feedback effects can be significant. Higher volatility leads to higher margin which leads to higher volatility. This just one issue that cannot be solved by lower rates. Micro market structure matters and should be followed closely.

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