US proposed rule change may inadvertently boost volatility: monthly IEA report

14 May 2012

Copyright: GraphicObsession

A recent move by the US government to reduce volatility and prevent excess speculation in oil markets may in fact have the opposite effect, according to the International Energy Agency’s latest Oil Market Report.

All futures exchanges – such as the Chicago Mercantile Exchange – have a clearing house, which intermediates all transactions and acts as guarantor of all trades that it has accepted from its members.

In order to prevent defaults by traders, clearing houses require that whenever an individual or a company wishes to buy or sell any form of futures contract on the market, they must pay a “margin”, which serves as collateral or as a “good faith” deposit given by the trader to the broker, ensuring the necessary funds are there in case of a default.

At present, ‘margins in commodity futures markets are relatively low, typically less than 10% of the value of the contract. Some policy makers argue that these low margins make it relatively cheap to speculate, which will lead to greater price volatility in futures markets. 

The US government’s proposed rule  – which has not taken effect yet as it still needs Congressional approval – is that significantly increasing the margin that has to be paid with every trade will act as a deterrent to aggressive speculation as traders will not want to take the risk of losing a large amount of money they put down as collateral. This will, the government contends, reduce price volatility and prevent excessive speculation.

The OMR, however, argues that this measure will limit the participation of certain traders, hedgers and cash constrained small speculators due to higher trading costs. This will leave the playing field open only to large traders with a small diversity of views.

In such a situation, the OMR believes that far from reducing volatility in oil markets, increasing the margin cost may well lead to a rise in volatility.

The Oil Market Report (OMR) is a monthly IEA publication which provides a view of the state of the international oil market and projections for oil supply and demand 12-18 months ahead. To subscribe, click here.

For IEA definitions relating to financial markets, click here.