Macaskill on markets: Margin calls and the VaR of war

Benchmark indicators of risk fell to unexpectedly low levels in late March as Russia’s assault on Ukraine ground into a second month of war. The ViX measure of US equity volatility – which is often dubbed the fear gauge – was steady at 22 as a month passed since the February 24 invasion by Russia and remained close to its historical average.

Fixed income volatility barometers such as the ICE BofA Move index were also down from their monthly highs, despite sharply higher Treasury yields as US Federal Reserve rate hikes began.

Are markets starting to look beyond the war in Ukraine and hoping that Fed chair Jerome Powell will soon be able to declare victory in his battle with inflation?

Not exactly. For one thing, the commodity markets that are a key source of inflation remain volatile.

And a dramatic increase in the margin required to trade commodities indicates that banks are worried about the creditworthiness of dealing counterparts.

The nickel market has provided the most dramatic – and at times comical – demonstration of the distorting role that can be played by higher margin requirements.

Russia and Ukraine are both big suppliers of nickel, and demand for the metal for electric vehicles was already strong before the onset of war provided another reason for higher prices.

Much of the chaos seen in nickel trading on the London Metal Exchange (LME) during March was due to concern about margin calls linked to short positions taken by Chinese nickel tycoon Xiang Guangda, the founder of Tsingshan Holding Group.

The LME, which since 2012 has been owned by Hong Kong Exchanges and Clearing, contributed to the confusion in the nickel markets. When the LME reacted to a nickel futures price rise of around 250% on March 8 with a retroactive cancellation of almost $4 billion of trades, it predictably enraged dealers who lost out on nominal profits.

A series of technology glitches and market closures after minimal activity in the following days added to a general air of incompetence at the exchange. It also led to speculation that links with China and a wish to help certain customers had driven decision-making by the LME.

Cliff Asness, the founder of AQR, one of the biggest hedge fund groups in the world, has been particularly vociferous in his criticism of the exchange.

“Yes, cancelling trades was their cardinal sin,” said Asness on March 18, in one of a blizzard of tweets complaining about the LME. "But a close second has been their keeping everything closed as [Guangda and his banks] get financing and physical nickel, and STILL not letting us trade."

The exchange denied these allegations.

“In the early hours of trading on Tuesday 8 March, it was the LME’s view that the nickel market had become disorderly, with prices no longer reflecting the underlying physical market. In the interests of systemic stability and market integrity, we suspended the market as soon as we could and cancelled trades from the point at which the LME no longer believed that prices reflected the underlying physical market,” the exchange said.

"The LME’s decisions were made with full regard to regulatory due process and were, in the LME’s view, in the interests of the market as a whole."

An insider added that the exchange operates independently from its parent company in Hong Kong.

The suspension of trading and reversal of deals could nevertheless be characterized as an effective bailout for Guangda, whose firm Tsingshan should eventually benefit from higher nickel prices as a producer, but faced a potential need to supply billions of dollars of extra margin at short notice as the price spiked.

Even after the cancellation of many trades, banks led by JPMorgan were still forced to broker a deal to ensure that he was able to post margin on his exposure. The margin standstill agreement and a secured liquidity facility arranged by firms including JPMorgan, BNP Paribas and Standard Chartered might leave the lenders feeling that they averted a potential write-down and emerged with better security on their exposure, but there are plenty of other signs of strains in margin provision.

Sharply higher margins are also being seen in energy markets, for example, leading market players to ask for government assistance in providing liquidity.

The European Federation of Energy Traders said on March 10 that margins to trade on exchanges were roughly eight times higher than they had been a year before and added that “providing targeted support for a limited period could reduce the risk of possible default”.

There is an obvious irony in a call for support from a group that features buccaneering trading companies such as Mercuria, Vitol, Gunvor and Trafigura as members or associate members. And the trade group’s simultaneous plea for the avoidance of price caps is arguably an audacious attempt to ensure profits are not disrupted when markets eventually calm down.

That may explain why supervisory authorities were slow to respond to calls for aid.

The need to ensure that mainstream energy suppliers can provide consumers with power during a period of volatility is also obvious, however, and some form of liquidity support may eventually emerge.

In the meantime, margin requirements are likely to be re-examined by banks in areas beyond the commodity markets that are currently seeing the most dramatic volatility.

The collapse of family office Archegos a year ago supplied a warning of how much difference an efficient margining and risk management policy can make to a bank when a major client suffers reverses in equity exposure.

Archegos caused around $10 billion of losses for its prime brokers, but the pain was unevenly felt, with Credit Suisse suffering by far the greatest hit at $5.4 billion, while some banks, including Goldman Sachs and Deutsche Bank, saw minimal impact.

Information asymmetry about margin exposure regularly takes some counterparties by surprise.

Attempts to restructure troubled Chinese property group Evergrande recently ran into trouble when the firm disclosed in a filing that unnamed lenders had control of $2.1 billion of deposits from one of its Hong Kong units, for example. That was news to most of the firm’s foreign bondholders.

The growing market for margin loans to technology investors such as SoftBank has also increased the risk for lenders that swings in the value of underlying collateral could leave them with insufficient security to cover their exposure.

Banks produce value-at-risk (VaR) figures with their quarterly results that give an average daily risk exposure across key markets, including commodities, currencies, equities and interest rates. The overall VaR number is calculated after allowing for a wide diversification effect that results in an average daily rate that can appear inconsequential.

Goldman reported 2021 year-end average daily VaR of $86 million, for example, which was down a bit from the figure of $94 million at the end of 2020.

VaR numbers for the first quarter at big banks are likely to be up while still appearing manageable when expressed as a single dollar figure. But strains in margining may provide a better signal of the real value at risk as an ongoing war in Europe adds to stresses on markets.