User 254952

Raising Margin Requirements May Spike Oil Prices Higher

Let me try to alleviate the confusion here...

For every buyer of a futures contract there is a seller. Additionally, both longs as well as shorts put up the same amount of margin to establish a position. Further, commodity-linked ETFs and other "securitized" commodity products are derived from futures contracts.

Here is a mind experiement to explain the thesis:

Let's assume there is one short seller who puts up $6k margin to control 1 contract/$100k short position. Let's also assume that there is one long offsetting this short who has fully funded his long position (ie, invested $100k) and purchased an ETF. For argument sake, let's say that the ETF provider who is backing the ETF buys 1 futures contract/$100k long position (requiring only $6k margin) versus the short seller previously mentioned and leaves the $94k balance in cash.

This is essentially an asymmetrical situation...

Now, if margin requirements are raised, who is going to have to come up with more $$$ to cover the requirement?

The short seller... he/she will have to either cover the position (that is, buy the contract causing upward pressure on prices), or he/she will have to come up with more money to maintain the position.

Meanwhile, the long ETF position which is fully funded will not be impacted in anyway, and he/she can remain long without having to come up with additional funds as he/she already put up $100k.

BTW, citizen782 understands the inside joke and is correct in his additional analysis.

As a final comment, let me explain why I wrote the article.

First, it was to highlight the potential distortions that securitized commodity-linked products have on the proper functioning of the futures market. Some of the responses here reflect misunderstandings of how futures markets work and how securitized commodity-linked products are derived from such markets.

Second, I wanted to point out the how improperly vetted legislation (eg, raising margin requirements) could cause price distortions. Enough time has passed since writing this article, and there has been sufficient documentation in the financial press of short term spikes related to short covering to validate that certain 1-2 day spikes were related to hedge fund short covering in oil. However, there is insufficient empirical data to relate how an increase in margins may have had an impact, although the NYMEX did raise margins on oil a few months ago.