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.