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  • 8.9.9-FUTURES MARKETS-FINANCING MARGINS

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  • Financing margins

     
     

    Financing margin calls on open contracts can make the use of futures markets very expensive for producers and exporters, partly because variation margins are always paid in cash. This does not apply to trading deposits, which can be covered by securities such as bank guarantees and treasury bills.

    Any user of futures markets should be aware that unanticipated calls for variation margins can be costly in terms of demands on their cash flow and the interest forgone on cash deposited with the clearing house. Therefore, a user should carefully consider how margin calls will be financed before entering into any commitments. See also 10, Risk.

    An (extreme) example: on 24 June 1994 the 'C' contract closed at 125.50 cts/lb. Just two weeks later the market closed at 245.25 cts/lb owing to frost damage in Brazil. This translated into a variation margin of US$ 45,000 per lot so an exporter with a short of 10 lots against physical stocks would have had to pay US$ 450,000 to meet the margin call - and within 24 hours at that! As a result of margin financing problems the open interest at that time was halved within weeks. Of course exporters would benefit from the increased value of their physical stocks in a situation like this, but might not always find it easy to convince any but the most experienced commodity finance banks of the validity of this argument.

    Merchants and brokers are often willing to help producers and exporters to overcome the problems that margin calls can create. In some cases, the broker will finance all the margin costs but in return the broker will expect a higher rate of commission or a discount on physical contracts. Brokers can be particularly useful in solving the additional problems connected with distant futures transactions. Often a high premium can be picked up for forward physicals but there is no liquidity for such far dates in the futures markets.

    However, most if not all of today's forward business in physicals is conducted on a price to be fixed basis, which has reduced the need to enter into far forward futures deals.  For information on Price to be fixed, or PTBF, see 09, Hedging and other operations.

    Someone who pays their own margins is entitled to receive cash payments of all credit variation margins. Additionally, if they pay the trading deposit in cash, they are entitled to receive interest on that money.

    A producer or exporter can reduce liability for margin calls by becoming a clearing member of the market (assuming that regulations in their country permit this). This means that all trades are held in their account with the clearing house and not by various brokers in the market. Once they become a clearing member, their liability is reduced because they are liable only for margin calls on their uncovered position with the exchange. A clearing member can offset their position on one contract against their position on other contracts. By contrast, a non-member's liability for margin calls is calculated separately for each contract.

    There are other advantages in becoming a clearing member: there is no longer the worry about the risk of a broker defaulting, and in some markets business can be transacted through locals who may give better service than the larger brokers. Locals are exchange members who trade on their own account but do not deal with clients outside the exchange.

    Trade houses play an important role in aiding producers, exporters and industry to overcome margin requirements. When a trade house enters into a transaction for physical coffee, either on a price to be fixed basis or on an outright price basis, it is usually also the trade house that takes up the obligation and risk of margin financing. This is of significant benefit to the coffee trade and plays an integral part in establishing long-term delivery contracts. Of course, the trade house itself must have strict financial and third party (counter-party) risk controls in place in order to avoid any excess margin calls in times of increased market volatility.