LME chief: bourse could revamp margining after nickel kerfuffle

Bourse could move to end permitted netting of IM and VM calls, says Chamberlain

London Metal Exchange (LME)
Photo: HM Treasury/Flickr

The London Metal Exchange (LME) may end its unusual policy of allowing clearing members to net initial and variation margin calls – a method aimed at reducing the funding burden of metals hedges on producers – as the bourse grapples with heavy criticism of its handling of extraordinary price moves in its nickel contracts in the wake of Russia’s war in Ukraine.

Clearing houses typically levy both daily initial margin – a set amount of a contract’s value paid in cash or non-cash alternatives to cover potential future exposure – and cash variation margin, which marks the position’s value to market. These two amounts are usually not nettable, with variation margin posted by either party held by the clearing house to guarantee the final settlement of the contract.

LME Clear does things differently: a total margin requirement is calculated at the end of each day, which includes initial margin, with members able to offset any positive discounted contingency variation margin from the final amount. This is designed to reduce the funding burden of meeting collateral demands on smaller to mid-sized members, many of which have limited treasury functions.

Matthew Chamberlain, chief executive of the LME, acknowledges that daily, non-nettable cash variation margin, known in LME parlance as realised variation margin (RVM), would be an easier, perhaps safer way to go.

“It’s fair to say that, from a pure risk management perspective, market-standard perspective, RVM would be an easier way to go,” Chamberlain tells Risk.net. “It probably does de-risk you in the event of a member default, because you don’t have offsetting variation margin.”

The bourse has tasked an independent reviewer with investigating how it handled the 250% skyrocketing of nickel prices on March 8 and the controversial cancellation of all trades that occurred in the market that morning, prompting fury from hedge funds and market-makers with long positions in the contracts. The market remained closed for a number of days afterwards.

Allowing netting of margin calls is relatively unusual. Initial margin is meant to cover the risk that a market participant defaults, and is therefore unable to continue to post variation margin calls and deliver promised cash or assets on a settlement date. Variation margin resets the trade’s value and prevents the build-up of counterparty credit risk, as a position moves in one direction.

Members are also permitted to post non-cash collateral to meet negative marked to market demands, something most CCPs do not facilitate. Market participants have pointed out that, while convenient for smaller members that may struggle to post acceptable collateral to the clearing house, the ability to net these two collateral flows means the system as a whole is riskier, as there is less overall collateral for the clearing house to use in the event of a default.

From a pure risk management perspective, market-standard perspective, RVM would be an easier way to go

Matthew Chamberlain, LME

“It is not paid in cash, it has to be covered in collateral,” explains a risk manager familiar with the LME’s clearing model. “So, if you’re making a loss, you have to provide collateral to cover that loss. If you’re making a profit, then that profit can be used to offset your initial margin.”

The setup is partly due to the historically large number of forward contracts cleared by the LME, participants note, which, unlike traditional futures, don’t feature a daily exchange of profits and losses.

Chamberlain adds that the outcome of the independent review could “tilt the balance” in favour of ditching contingent variation margining.

“An incident like the nickel situation will cause us to look at that, again, from the market stability, market risk market standardised market infrastructure point, and I’m sure the independent reviewer may have a view,” he says. “And it’s possible that that view tilts the balance.”

The LME has toyed with the idea of ditching contingent variation margin altogether, but many producers have called for it to remain, as it allows for collateral flows to more closely match physical deliveries.

In June 2021, the LME revealed the results of a discussion paper that solicited market opinion on a range of points, including whether to keep contingent variation margin (CVM) or move to more traditionally daily cash margining. LME said that it would start a “feasibility study” to consider a middle-ground approach that would “recreate the cashflows of a CVM model for RVM contracts”.

However, a wholesale move to RVM would not occur until the feasibility of the new approach was properly assessed, it added, and until the new VAR margin framework was rolled out.

“Our physical customers, many of them do like the CVM approach,” adds Chamberlain. “And they have a good reason for that. They believe that clearing house margin cashflows should match their physical contract cashflows, and that means they ideally want those cashflows to be at the end of the contract.”

Editing by Tom Osborn

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