Margin Hikes On Silver Should Dampen Open Interest, But Not Necessarily Prices

Posted 05/17/11 by Jason Goepfert                                                                                       Archive »


There has been intense interest from traders, regulators and politicians related to the performance in some commodities, particularly silver.  In response, the margin requirements to hold some futures contracts, again particularly silver, have been increased.


Exchanges supposedly set their margin requirements using computer algorithms based on historical and implied volatility, but the fact of the matter is that the ultimate decision is discretionary...and they are not immune to political pressure.


The question now isn't whether margin requirements on silver are going up - they already have, astronomically - the question is what impact it will have going forward.


What kind of dent in sentiment does such a hike tend to have?


Unfortunately, getting historical margin requirements has proved to be exceptionally difficult.  I have about 10 years' worth for most commodities, but only 7 for silver.  It's not for lacking of trying, or expense.


Assimilating all the research, the conclusion boils down to this:


Margin increases tend to greatly lower trading volumes and open interest, and they stabilize price action to where it was before the event that triggered the margin change.  That holds especially true in markets like silver where speculators are a larger influence.


None of the studies suggested that price action itself was consistently impacted by margin changes.  It was only trading volume and open interest that were influenced in statistically significant way.


The chart below shows silver futures, along with the initial margin requirement for speculators, which obviously has gone parabolic.  Aggregate open interest has, true to historical precedent, fallen during that time.



One potential difference this time is that the studies are based on the idea that speculators in silver futures are "jump on the bandwagon" types.  But based on data from the CFTC, we're not seeing that this time.  Large speculators are not that net long the futures, and didn't ramp up their exposure as it rose (possibly due to the introduction of exchange-traded funds that are easier and more liquid than futures).


The ETFs may throw a wrench into what the exchanges are trying to do, but historically these margin hikes have led to lower volume and lower volatility.  For those who are suggesting that it necessarily means a decline in silver, they may have a point...but it's not supported by any empirical research that I can find.  Silver prices will fluctuate based on their own merit, and not based on arbitrary margin requirements.


For those who want more detail, here are the relevant conclusions from the two most topical studies:


"In summary, there is strong evidence that (1) the exchange used margin requirements to affect market activities; (2) margins were usually raised if the trading pattern had been heavy; and (3) except for the open interest in the 1979-1980 period, changes in margin requirements were effective in stabilizing the trading pattern prevalent prior to the change."


 - Margin Requirements and the Behavior of Silver Futures Prices, Christopher K. MA, G. Wenchi Kao and C.J. Frolich





"There is a clear causal negative margin effect on trading volume and open interest. Trading activity moves away from...the metal with the higher...margins.  [a]10 percent increase in margins is associated with a drop in average trading volume of 1.38 percent, a drop in average open interest of 1.51 percent, and a drop in the growth rate of open interest of 2.96 percent."


 - Margin Requirements, Price Fluctuations, and Market Participation in Metal Futures, Journal of Money, Credit & Banking, Gikas Hardouvelis and Dongcheol Kim


Hardouvelis and Kim (1995) examine metals futures contracts. They exclude silver contracts during the Hunt Brothers squeeze period arguing that the special circumstances of the period would contaminate their sample.


They found strong evidence that high metals futures margins reduce contract open interest, but no evidence that higher margins attenuate contract price volatility.  Indeed their evidence suggests that any empirical margin-volatility relationship in the data owes to the prudential activities of the futures clearinghouses. Higher volatility leads the clearinghouse to increase margins, but the increase in margin has no measurable effect on contract price volatility subsequently.



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