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Higher Limits Increase Brokerage Risk, Capital Requirements

August 15, 2011
By: Fran Howard, AgWeb.com Contributing Writer

The CME Group announced Aug. 9 that it had received Commodity Futures Trading Commission (CFTC) approval to increase daily price limits for corn futures and options. As a result, daily price limits for Chicago Board of Trade corn futures, corn options, and mini-sized corn futures will increase to 40 cents per bushel from the current 30 cents per bushel, effective Monday, Aug. 22.

David Lehman, managing director of commodity research and product development for the CME Group, says that increasing the daily trading limit should reduce the number of limit moves in corn, thus decreasing volatility. But not everyone is buying that premise.
 
Participants in AgWeb’s online poll overwhelmingly oppose the CME Group’s decision to raise the daily trading limits on corn. More than 81% of those who responded to the poll opposed the increased limit, while 15% favored the increase and 3% were unsure.
 
Under the current 30-cent limit, if prices close limit up, producers who hedged their crop would need to replenish their margin accounts with $1,500 for every 5,000-bushel futures contract sold, says Chad Hart, agricultural economist with Iowa State University. Once the limit is expanded to 40 cents, a limit-up day would require hedgers to put $2,000 into their margin account for every contract sold.
 
"That’s a lot of capital to be locking up in a margin account," says Hart. Partly, producers hedge their corn crop because they want to hold it to sell it at a later date at a higher price, and as such might be short on capital to come up with the margin calls, he says. The expanded limit would thus require better cash management or more caution on the part of hedgers.
 
"If you are a grower who has never hedged before, it doesn’t affect you," says Hart. Only those producers who have been hedging under the current, lower limit will notice a difference in the capital requirements.
 
While coming up with more capital could be painful for some producers, the CME Group argues that longer term, an expanded limit should mean fewer limit-up days and thus fewer margin calls.
 
In a paper titled "Corn Price Limits and Margin Requirements" in which the CME Group addresses the concern that hedge margins will increase following an increase in daily limits, the authors note: "Price limits do represent the maximum daily price change, and thus represent an approximate upper limit for margin requirements. However, evidence does not show that Corn futures margins increase following an increase in price limits."
 
Following the 1993 and 2008 increases in the daily corn limits, margin requirements increased prior to the date the limit was expanded, but margins did not increase following implementation of higher limits. Instead, in the month following these limit increases, margin requirements actually fell. "These results suggest that high volatility and not higher price limits caused margin increases," the paper notes.
 
Not everyone, however, sees it that way. "I think expanded limits will increase volatility," says Diana Klemme, vice president with Grain Service Corporation, Atlanta. "When the morning rhetoric says it’s going to be a limit-up day, the stampede will push further before selling comes in to stabilize the market. I can’t accept it will decrease volatility."
 
In some ways, Klemme says the expanded daily limit on corn makes sense with corn prices now trading in the $5/bu. to $8/bu. range instead of the $2/bu. to $4/bu. range. Daily limits, regardless of whether they are 30 cents or 40 cents, act as circuit breakers, increasing the time it takes for prices to move to new levels, whether that’s up or down. "If corn needs to go to $9, do we have to do it immediately? The limits don’t prevent prices from going to where they need to go, but limits act like circuit breakers, which allows people to get their margin money lined up," she adds.
 
Expanded limits will also increase a brokerage house’s single-day risk profile, which could affect some producers. For instance, Klemme says, if a brokerage firm has customers who have been slow in sending in their margin money, it might insist on a one-day payment now that more money will be at stake when before the firm might have allowed a couple of days. The brokerage firm could also limit the number of contracts that slow-paying customers can hold.
 
"I’m a firm believer that circuit breakers serve a purpose and the world will not be harmed if we take longer to get to a new price level," Klemme says. Stopping black box trading, which is when computer algorithms determine timing, price, or quantity of orders often without human assistance, is a good thing, she adds.
 
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COMMENTS (2 Comments)

Christopher Lehner
For close to 30 years I have been a broker and analyst specializing in grain and livestock risk management and trading. When the expanded 40 cent limit was first proposed, I wrote to several committee members expressing my concern. A few months ago when it appeared the new limit would pass, I wrote members. For some reason not one person responded to my emails and letters. They had their mind set from the start. Why weren't all grains given new limits? Often when one grain moves limit, it is common for the others to follow. Expanding the limit will put all grain margins closer together and help to equalize fund balancing. It can't be any clearer.
It will be increase the margin requirements and the hardship will fall on the user that is not experienced using futures.
I feel, the new limits were also added to enhance the OTC markets and for the traders using option strategies. Margins and often the lack of margins are one of the primary reasons the OTC markets are growing. Unfortunately very few brokers or producers can ever use them. They are used by large accounts that have fled the exchanges because of high margins.

Secondly, traders of size often use options to offset and to protect futures trades. Options were intended from the beginning to be used to protect the underlying futures positions. If options are used, limits are preset by the user. It is sad but broker and user education has limited their proper use. Brokers jumped on options because they had a trading instrument, they could sell as a limited risk investment when buying puts or calls. Grain producers understood limited especially after hearing the horror stories of losses without being thoroughly taught why hedges are placed, options can offset futures and additional capital may be needed until delivery.

Unfortunately too many brokers don't understand hedging even those calling themselves as agricultural specialists. If options are used as intended, limit moves aren't a concern and risk is minimized. Raising the limit to 40 cents won't do anything but chase the hedger away. Did it stop limit moves when limits were expanded in the past? No.

The expanded limit should be seen for what it truly is; a way to eliminate small traders both hedgers and speculators. Large traders don't want the accounting to offset 1 and 2 lot trades. Get rid of the traffic. If the CME Group truly wanted to do something, they could spend a few dollars on option education or if truly concerned about risk, they could require future trades to be offset with options. But face it, the trillions of dollars coming into the CME Group and future growth isn’t from the hedger. It is from the large accounts and the big boys have achieved their goal.

6:20 PM Aug 15th
 
Christopher Lehner
For close to 30 years I have been a broker and analyst specializing in grain and livestock risk management and trading. When the expanded 40 cent limit was first proposed, I wrote to several committee members expressing my concern. A few months ago when it appeared the new limit would pass, I wrote members. For some reason not one person responded to my emails and letters. They had their mind set from the start. Why weren't all grains given new limits? Often when one grain moves limit, it is common for the others to follow. Expanding the limit will put all grain margins closer together and help to equalize fund balancing. It can't be any clearer.
It will be increase the margin requirements and the hardship will fall on the user that is not experienced using futures.
I feel, the new limits were also added to enhance the OTC markets and for the traders using option strategies. Margins and often the lack of margins are one of the primary reasons the OTC markets are growing. Unfortunately very few brokers or producers can ever use them. They are used by large accounts that have fled the exchanges because of high margins.

Secondly, traders of size often use options to offset and to protect futures trades. Options were intended from the beginning to be used to protect the underlying futures positions. If options are used, limits are preset by the user. It is sad but broker and user education has limited their proper use. Brokers jumped on options because they had a trading instrument, they could sell as a limited risk investment when buying puts or calls. Grain producers understood limited especially after hearing the horror stories of losses without being thoroughly taught why hedges are placed, options can offset futures and additional capital may be needed until delivery.

Unfortunately too many brokers don't understand hedging even those calling themselves as agricultural specialists. If options are used as intended, limit moves aren't a concern and risk is minimized. Raising the limit to 40 cents won't do anything but chase the hedger away. Did it stop limit moves when limits were expanded in the past? No.

The expanded limit should be seen for what it truly is; a way to eliminate small traders both hedgers and speculators. Large traders don't want the accounting to offset 1 and 2 lot trades. Get rid of the traffic. If the CME Group truly wanted to do something, they could spend a few dollars on option education or if truly concerned about risk, they could require future trades to be offset with options. But face it, the trillions of dollars coming into the CME Group and future growth isn’t from the hedger. It is from the large accounts and the big boys have achieved their goal.


6:19 PM Aug 15th
 



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