How Rising Margin Costs are Reshaping Commodity Trading

Commodity trading firms use a combination of derivatives, alongside physical positions, as part of their overall portfolio, with the majority of these trades being subject to margin. But these trades are no longer as efficient as they once were, with a combination of high margin levels and high funding costs impacting returns.

In 2008, firms were potentially able to achieve around 10x leverage on their trading – paying only 10% of the overall value of their portfolio in margin. But then the global financial crisis, following the bankruptcy of Lehman Brothers, changed everything. The new regulation, such as Dodd-Frank and EMIR, introduced in the aftermath of these events, forced an increasing number of firms to post collateral for their derivatives positions.

The increase in the range of derivatives that are now cleared and the amount of collateral that firms have to post has highlighted the issue of fragmentation. Exchanges are inherently regional and product specific, meaning that offsetting positions will be margined separately.

The portfolio-based models used to calculate Initial Margin, such as the older scenario-based algorithms like SPAN and IRM 1, or the newer VaR based models like SPAN 2, IRM or Eurex Prisma, will net potential profits and losses under their various scenarios for positions that are cleared under the same CCP, but for other parts of the portfolio a completely separate Initial Margin will be calculated, leading in effect to gross margining.

This fragmentation led to a decrease in the leverage available to firms, with many only able to achieve around 5x. But that was before the additional volatility of the past few years.

It’s been a rocky ride, including Covid, the Russian Invasion of Ukraine, the disastrous UK mini budget and some major weather events. The resultant price volatility has led to significant increases in margin requirements, with hikes of over 100% in a short period of time not unusual. At times, firms found that they were only able to achieve 0-2x leverage, with margin requirements at times exceeding trade value.

Although some of the volatility has gone, margins have remained higher than the historic norm. The current geopolitical situation and the impact of climate change means that it is likely that events could easily lead to a return to margin rates of above 50%. And that is without the introduction of mandatory clearing for more products over time.

How To Reduce The Level Of Margin Requirements

The recent past has left derivatives users with a difficult decision:

• Trade based on current margin levels without any additional funding, leaving yourself exposed to critical liquidity risk if volatility returns.
• Source additional funding to cover potential future margin increases, but this will be a drag on returns.

However, there is an alternative. Firms still need to decide the amount of liquidity risk they are willing to accept, and use stress testing to size their funding requirements appropriately. Without any other action, the funding level will be based on their current portfolio and the way that margin is calculated on this. But there are ways to optimise margin requirements to maximise the available leverage:

Same Product Using Alternative Venues

There are lots of examples of the same product being available on multiple markets:

• TTF gas futures are available on ICE, EEX, Nasdaq and CME, although the contract specifications vary (for example, some are deliverable whereas others are cash settled).
• Brent and WTI futures are available on both ICE and CME, although the level of open interest varies.

Given that the products are the same and that all the clearing houses are calculating margin based on the same or similar regulation, it is surprising how different the requirements can be.

Example

The following table shows example margins calculated on Dutch TTF Gas  futures at different CCPs.

It can be seen that where CCPs stand in relation to one another is dependent on the expiry of the future. For example, CCP3 margin is less than CCP2 for a Dec 2027 future, but more than CCP2 for a Dec 2025 or Dec 2026 future.

And looking specifically at the margins calculated, for a Dec 2025 contract this could mean a difference in margin of over 80% between CCP1 and CCP3..

Same Risk Using Alternative Products

There can be different ways of trading the same level of risk that can have a significant impact on the level of margin required or the timing of any cash flows, both of which feed into liquidity requirements:

• Different product types can be used, for example, options can be used to simulate a future position.
• For many underlyings there is a choice of cash settled or deliverable derivatives.
• Many products can be traded both cleared and bilateral.

For these alternatives sometimes the difference in margin is small, but at other times it can be massive.

• For some bilateral trades no margin will need to be paid making it a significantly cheaper option.
• However, if the trade is subject to UMR, unless you are using the $50M threshold, then the margin required can be a lot higher than that calculated for cleared trades. Differences of over 4 times are often seen.

Same Portfolio Using Alternative Clearers

Choosing where to place your cleared business can have a significant impact on the margin charged. Optimising the level of broker costs is obvious. Each will have its own schedule of charges and may also use their own margin algorithms.  But if they are replicating the CCP margin calculations they will also have varying multipliers that will be applied.

Outside of the use of different algorithms or multipliers, there are two ways that choice of broker can impact the actual margin level:

• Taking into account existing positions held with the broker is important so that any offsets can be maximised.
• But the biggest savings can be made by splitting positions between brokers to minimise the liquidity charge.

Example

With the introduction of the non-linear liquidity add-on, the traditional way of allocating business between clearing brokers, putting all positions from one market at the same broker, is now suboptimal. Any large outright position will incur significant margin in order for the CCP to cover the risk of close out on default. If you allocate your trades by market it may give the maximum position offset, but also maximum liquidity charge.

Assume you have a position in LME Tin and allocate it all to a single broker:

The initial margin calculated would be as follows, based on different sizes of positions:

It is clear that the larger the position the higher the effective margin rate per lot. A more efficient way of allocating positions needs to be found which will minimise the margin calculated by clearing brokers.  This means not just maximising the offsets between contracts but also minimising positions for a given product allocated to a broker.

Placing a maximum of 150 lots at any given broker would significantly reduce the total margin paid. The margin on this position would be $2,843,835 which would result in the following initial margin:

For the larger position this is a margin saving of around 10%. And the larger the position the higher the savings will be.

Conclusion

Since 2008, the level of margin charged when trading derivatives has increased considerably. From an average of around 10% on a portfolio, a combination of regulation, fragmentation and volatility has severely increased this. At its worst margin rates of over 100% were seen.

If firms want to continue to benefit from derivatives and not let margin be a drag on their returns then they need to look to optimise their requirements. Making the right choice of where and what to trade can have a significant impact on margin, allowing firms to limit the amount of funding required without exposing themselves to excessive liquidity risk.