There was one other point that I did not cover in my last post (Rumblings of Markets...), due primarily to 2 reasons - one, the post was getting too long for audience's perceived comfort (in my view) and two, this is a lesser known, less talked about, but an extremely important point nevertheless, which needed a separate coverage.
And the point is about exchanges increasing margin requirements on various contracts. Margin requirement is the minimum amount that a trader needs to deposit with her broker / exchange in order to take a futures contract. This is apparently being done to remove some of the speculative money from the markets. We'll jump in into the dense world of commodities, but first, some news for those of you who have skipped this important piece.
As per Bloomberg, "Ice Raises Margins on Sugar Futures by 9.9% as of Close Nov. 12" which lead to a sell-off in raw sugar prices that was so sharp, that it beat all records set in the last 22 years ! Simultaneously, ICE also increased margins on cotton, leading to a 2.7% sell-off. CME raised margins on soybeans, while Chicago exchange did so for Silver (which tanked 7.1% later). If you would like to, read this good piece from WSJ Online here.
Back in 2006-08, when authorities in India accused commodity futures for pushing and keeping prices of physical commodities higher, the ones who did not support this view said that futures prices are in fact determined by the physical prices. So if sugar demand goes up / supply goes down, the mandis / local markets will push the physical prices of sugar up, and thereby the futures prices will also go up since physical prices are an input to calculating futures prices. If this does not happen, there is an arbitrage opportunity which allows prices to come back in sync. This is another way of saying that the tail (futures market prices) cannot wag the dog (physical market prices).
But going by the events listed above, it seems like the futures prices were actually being held up to some extent by speculators and it wasn't entirely tied to physical prices. Such a sharp sell-off in various commodities underlines the fact the speculative money can in fact, keep the prices artificially high. The margin money is the life-line of traders, its what they calculate ROI on, its what is churned n times a day to make money. E.g. if we assume that the margin required for 1 futures contract is around Rs. 25000, a trader with Rs. 50000 will be able to take only 2 contracts in either 1 or 2 different assets. On the other hand, a trader with Rs. 10,00,000 (ten lakhs) will be able to take 40 such contracts. Assuming both are normal, disciplined traders, its an easy guess who will make more money. Thus, margin money determines your churn, which affects your profitability directly. Any increase in margin money requirements slows the churn cycle so if 0.5% daily returns were good earlier with X margin money, nothing less than 0.75% daily return is good with 1.5X margin money.
Besides, the margin money requirement also has a contagion effect: You need more margin money, you decide to pull out some money from some other trade, ----> that asset prices goes down, ----> traders holding that asset get margin calls ----> they sell something else -----> that asset prices goes down...and so on. Besides, stop losses start getting triggered, which leads to further sell-off, leading to further downslide...and so on...not just in the same market / asset class, but in others as well.
This is probably one of the major reasons (apart from the ones given in my last post), which has lead to a sharp sell-off in various asset classes across the globe. It looks likely that this sell-off will continue for some part of next week as well, till traders re-align their portfolios again.
But notice how all these margin requirement hikes are happening across exchanges across geographies simultaneously...giving an eerie feeling of an implicit dictum from the big daddy of commodities...(but its just my guess, I could be entirely wrong here). Also, notice how these requirements have been upped in commodities which China imports heavily...(sugar, cotton, soybeans). [Co-incidence anyone?]
They have good reasons to do so - one, they are faced with inflation issues just like in India (any they're hoping that this move will cool down prices which will be reflected in lower inflation figures), and two, with their currency appreciating against dollar, their exports will take a hit and so they might have wanted to make some downward adjustments to their import bill as well (to keep trade deficit in check). If these are indeed the reasons, expect margin tightening in more commodities, in more markets.
There is just one thing which can derail the above tactic - the producers / sellers of these commodities, who will not be very happy with the falling prices (some of these players are really really big in the market). Besides, typically, their sale contracts are not based on end-of-day prices, but more on monthly average / quarterly average prices, which will come down drastically with the effect of such falls. Also, with falling prices, the chances of defaults by the buyers increases drastically (not very uncommon) further putting in question the actual sales figure done by these producers / sellers for this month / quarter.
Expect these players to come back big time to push the prices back up again. If they need to borrow money to put in the markets, they will. Expect banks to increase their lending to these guys and to usual trading companies to make good their increased Working Capital Requirements (due to payment of higher margin money). Whether and how soon the prices come back up will really depend largely on such players in the market.
But till then, it'll be the case of the tail wagging the dog.
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