Margin calls and Clearing Houses

If two investors are striking a deal to trade an asset in the future for a certain price, there are obvious risks. One of the investors can "disappear" or simply step back on his commitments in some way. Alternatively, the investor can be out of funds to honor the agreement. If the deal was agreed directly between two investors, on the Over The Counter (OTC) market, the both are carrying all these risks. Another, more secured option, is to strike the same deal on the organized exchange market, whose key role is to avoid defaults. Natural question would be, why don't we use the second option only? Even more surprising is the fact that the most of such trades are still done on the OTC market. Something goes wrong here, isn't it? In fact no, in order to secure trading, the exchange requires all participants to post a certain amount of money aside. So investors have to pay when the contract is signed on the organized exchange, while on the OTC market they have not to do that. For the most of investors "have to pay" means less money to invest elsewhere => less exciting. In this article we will examine the way how the deals on the organized exchange are regulated.

Daily Settlement and Margins

As usually we are going to take an example to illustrate how the things are fitting together. Let's consider an investor who calls its broker to buy 2 December oil futures contracts. Let current future price is 100 USD per barrel. To simplify we consider that contract size is 1 barrel. So our investor has contracted 2 barrels at this price for a total amount of 200 USD. To secure the transaction the broker will require to post an initial margin of 50 USD (25% of the contract amount). This amount will be deposited in a margin account, managed by the broker. So at the time contract is signed the investor have to pay 50 USD to its broker.

The price of the oil is fluctuating through trading days, so the price of the barrel tomorrow won't be the same as it is today. Obviously the price of the contract will follow this price change. At the end of each trading day, the margin account is adjusted to reflect the investor's gain or loss. This practice is referred to as daily settlement or marking to market. If barrel price decreased by 4 USD then 4 x 2 = 8 USD will be withdrawn from the margin account and it will pass to 42 USD from initial 50 USD. If next day the price of the barrel would rebound of 3 USD, then the margin account would rise back to 48 USD.

But what would happen if the barrel price falls drastically? In this case we are facing a risk that the margin account could become negative and obviously it is not something that exchange would accept. To avoid such a situation maintenance margin comes into play. Maintenance margin is lower than initial margin and it serves to define some kind of red line to the investor. Once this red line is reached the broker asks investor to top up its margin account to bring it back to the initial margin level (50 USD in our example). Let's imagine that that broker defined a maintenance margin as 80% of the initial margin or 40 USD. So if barrel's price falls by 5 USD or more the broker will ask investor to top up his margin account by 10 USD (or more) to return back to 50 USD account. In this situation the investor has to pay again.

Basically that's it.... This is how the exchange is regulating future contract deals.

Clearing

All this process is pretty straightforward and hopefully is clear at this stage. Broker is strongly involved into the settlement process, but what happens if broker itself fails to meet its commitments ? Indeed broker is just a financial company that can be solid and strong but also weak and fragile. The latter characteristics are not acceptable for futures trading supervision. This is a reason why clearing houses where created. Clearing house is an intermediary in futures transactions. It has a number of clearing house members or clearing brokers, who must post funds with the clearing house. Brokers who are not members themselves must channel their business through a member. So we have some kind of chain where investor is required to maintain a margin account with a broker, broker - with a clearing house member and finally clearing house member - with the clearing house:

Investor => Broker => Clearing House Member => Clearing House

If investors deals with a broker who is already a member then this chain simplifies by one layer. As clearing house member maintain a margin account at the clearing house then clearing house can require to top up its account if it reaches some level considered as dangerous. This process is known as a clearing margin. This works in the same way as between investor and its broker; the only difference that there is no maintenance margin on this level. Indeed every day the account balance for each contract must be maintained at an amount equal to the original margin.

Netting

In determining clearance margins, the clearing house calculates the number of contracts outstanding on either gross or net basis. Suppose a clearing house member has 2 clients : one with a long position in 20 contracts, the other with a short position in 15 equivalent contracts. Gross margin would calculate clearing margin on the basis of 35 contracts; net margining would calculate on the basis of only 5 contracts. Basically long and short positions are mutually compensating. Most exchange currently use net margining.

Conclusion

The level of margin can sometimes be used as a tool to control futures market activity. Lower margin levels would allow speculators to to take larger positions with the same amount of money being put aside. On the other hand higher margin levels are likely to make debt based speculation less attractive. For example in mid-2008 the oil prices reached historical levels due to derivatives speculation. These prices were undermining the real economy and I don't still understand why regulators didn't use this tool to take control over the speculation wave.

Finance: From Business to Business

Today's large financial firms are hosting various and sometimes complex activities. They are rarely can be considered  as banks in a classic definition of the term. Indeed many financial institutions are involved in commercial and investment banking, capital management and sometimes even insurance business. Let's have a look into the structure of a typical financial institution and try to understand how all its parts are fitting together.

Commercial Banks

Commercial banks are the banks having the most traditional role of taking deposits and making loans while loans interest is greater than the interest paid on deposits. So the main source of revenues for a commercial bank is a spread between the cost of funds and the lending rate. Depending on the clients and amounts implied, commercial banking can be classified as retail banking or wholesale banking. Retail banking deals with private individuals and small businesses while wholesale banking provides banking services to medium and large corporations, investment funds and other financial institutions. Obviously the amounts of loans and deposits much higher in wholesale banking than in retail banking.

Investment Banking

This is probably the most obscure business in the banking sector. This obscurity is not necessary related to a lack of transparency but because the investment banking is holding a lot of various activities underneath. Public media are often presenting the investment banks as a group of conceited and insatiable traders who are capable to drive the world's economy to a collapse just to increase their own profits. Such persons certainly exist in the investment banking but fortunately this is not what the business is targeting for.

The main activity of investment banking is raising debt and equity financing for corporations or governments. The typical scenario is when a corporation approaches an investment bank when it needs to raise additional capital. This raise of capital can be achieved by issuing of a corporate debt, public offering of common stocks or some hybrid instruments such as convertible bonds. Basically investment bank can be seen as a mediator between a corporation which needs extra capital and investors who are happy to invest in it via capital markets.

Another important role of the investment bank is to offer advice to corporations in terms of merges and acquisitions, corporate restructuring etc. They will assist in finding mergers, takeovers, break down corporation into divisions to sell them separately to other corporations.

Investment banks can even design and sell to its clients custom financial products. These products can be standardized or not. The examples of these products are the warrants, options, ABS, CDO, CFD etc. Not standardized products are often called structured products and they are designed to address concrete client's needs, usually to hedge from some specific risks. Often investment banks are providing liquidity for these products in order to allow investors buying or selling them at any time. This liquidity management activity is often referred as market making.

Prop Trading

Proprietary trading refers to an activity when a bank takes a speculative position in the hope of making a profit. In other words it trades for its own account. The trading firm can trade stocks, bonds, currencies, commodities, their derivatives, or other financial instruments with the firm's own money. They may use a variety of strategies including very aggressive ones much like a hedge fund. Large investment banks often have this activity along with brokerage business. This is probably the most famous and contested activity that we can come across in various Hollywood movies about traders and large investment banks. For that many people have a wrong impression that this is the only activity of the investment banking business. The reason of criticism come from the definition of the "own account". For a large financial institution that has an investment banking activity the "own account" often means "depositors money"....

Brokerage

Brokerage firms are facilitating the buying and selling of financial securities between a buyer and a seller. Brokerage firms don't have any particular investment strategy, they are just processing client orders. Brokers can be considered as a middleman between client and the capital markets where clients can be asset managers, hedge funds, institutional investors, pension funds or individuals. Brokerage firms are taking profits from the commissions charged to their clients. In practice the real brokerage firm suggests many other services to its clients like researching the markets, recommendations of what to buy or sell etc.

Worth noting that brokerage firms are not just forwarding the orders to the market. It can be the case for some small orders. But the main chunk of the added value of the broker relies in the large orders and order baskets processing. Indeed very large orders cannot be directly sent to the market as they are likely to unbalance supply and demand (order book) and the price of the instrument will jump or fall drastically. This is where various trading algorithms are coming into play. Brokers are trying to provide a better price to its clients so they are usually splitting large orders into smaller parts and sending them to the market at an appropriate time defined by the strategy. Sometimes brokers are providing custom trading algorithms to their clients who are interested in some specific trading of their orders.

Asset Management

The objective of an asset manager is to invest client's money in the most efficient way. In the most of the cases asset managers suggest collective investment schemes like mutual funds, pension funds, exchange traded funds etc. to their clients. Asset managers are mainly targeting small and medium investors who are looking for broader diversification with a minimum costs. Indeed it can be difficult for a small investor to hold enough stocks to be well diversified and maintaining a well-diversified portfolio can lead to high transaction costs. As long as asset managers are mostly targeting small investors their business is pretty much standardized and overseen by financial regulators.

Usually asset managers have a benchmark that is clearly mentioned for each product being commercialized. This benchmark can be a broad index like S&P 600, Dow Jones, Dax, some bond or commodities index etc. Asset manager can commercialize funds with active management and/or index funds. Funds with active management are trying to beat the benchmark with respect of the fund's risk profile. Index funds and Exchange Traded Funds (ETF) are just following benchmark without applying any extra investment analysis. ETFs become more and more popular as they are traded on the market as usual common stocks while traditional mutual funds are not traded on the market and using subscription approach based on some fixed price per fund's share. Index funds and ETFs are much cheaper in terms of management fees than actively managed funds what partially explains their success. However actively managed funds allow investors benefiting of the manager's experience and knowledge.
Asset mangers earn money with management fees. Each year fund manager charges some percentage of assets to its clients. These fees are deduced from fund's overall performance. Some funds have extra entry fees and even exit fees but it becomes less and less. Actively managed funds can charge around 2%-5% per year while index funds and ETFs are usually charging around 0.2%-1.5% plus eventual leverage costs if fund is using leverage.

Criticism
There is a lot of criticism towards asset management in general and especially actively managed funds. Due to the strong regulation of the actively managed funds they are often constrained to implement the most efficient strategy. For example even if a fund manager is expecting stock market downturn, he can be forced to be invested at some level of its assets by regulators. This level can reach 90% in some cases! Another point of criticism is that asset manager always wins. Sounds funny but it is true. Even is the benchmark fell of 40% and the fund indexed on this benchmark fell "just" 30% the asset managers did a great job and they will still charge fees to their clients. Another VERY annoying point about actively managed funds is that subscription becomes valid in some period of time after client had requested it. Usually the subscription is validated next day for the next day price! With current market volatility it can be very risky to subscribe this way. Taking into account this criticism many investors consider that benefits of active management by professionals are offset by higher fees, regulatory constraints and funds subscription specific risks. Even worse statistic shows that actively managed funds are very rarely beating the broad market in the long term.
Index funds and especially ETFs are becoming more and more popular. They are widely used by investors implementing diversified strategies. The only criticism I'd mention that sometimes investors are buying several index funds holding same instruments. For instance both French CAC40 ETF and Eurostoxx 50 ETF are likely to hold Total and Sanofi stocks. So this is an example of the false diversification.

Hedge Funds (Alternative Investments)

Hedge funds are different from the asset managers in that they are subject to very little regulation as they are targeting financially sophisticated individuals and organizations. Hedge Funds can design their own strategies and take profits from both bullish and bearish markets. They don't have a strict benchmark but they can have a general investment direction like American stock market, commodities trading, fixed assets, currencies etc. But from the investor's perspective, even if a hedge fund is labeled American stock market fund, it doesn't mean that if market would fall the fund is likely to loose money. Hedge fund managers are expected to benefit from all opportunities even while market crash. Another difference between traditional asset manager and a hedge fund is that the latter is likely to use leverage. It means that hedge funds are often borrowing money to increase their performance.
Obviously hedge funds are much more expensive. They are charging fees to investors not only for usual management, entry/exit fees, but also they are taking a significant percentage of fund's performance. So hedge funds are always winning but after a good year they are winning even more! Investors giving their money to a hedge fund are strongly exposed to the manager's competencies and experience. Many hedge funds are going bankrupt every year especially during financial crisis. For this reason financial regulators are absolutely right in limiting the access to these sometimes very efficient investment schemes.

Private Banking

This is a special form of relationship between a bank and its client, usually a wealthy individual. This relationship includes premium services and a form of custom asset management designed to the specific client needs. For wealth management purposes, individuals have accrued far more wealth than the average person, and therefore have the means to access a larger variety of conventional and alternative investments. Private banks aim to match such individuals with the most appropriate options. In addition to providing exclusive investment-related advice, private banking goes beyond managing investments to address a client's entire financial situation. Services include: protecting and growing assets in the present, providing specialized financing solutions, planning retirement and passing wealth on to future generations. Private Banking business is very developed in Switzerland.

Private Equity Firms

A private equity firm is an investment manager that makes investments in the companies that are not traded on the stock exchange. Private equity consists of investors and funds that make investments directly into private companies or conduct buyouts of public companies that result in a delisting of public equity. Capital for private equity is raised from retail and institutional investors, and can be used to fund new technologies, expand working capital within an owned company, make acquisitions, or to strengthen a balance sheet. A private equity investment will generally be made by a private equity firm, a venture capital firm or an angel investor. Each of these categories of investor has its own set of goals, preferences and investment strategies; however, all provide working capital to a target company to nurture expansion, new-product development, or restructuring of the company’s operations, management, or ownership.

Inflation and Deflation

Looking few years back we often realize that for the same amount of money we were able to buy more things. Some people are complaining that even with a higher salary today they are poorer than earlier. Finally talking to our grand parents we can easily realize that when they were young they were living in a completely different price system than we do. These phenomenons can be explained by probably the most popular economic indicator called inflation. Inflation is very often mentioned by different people in various situations but often there is a lot of confusion around this term. Let's look inside the mechanisms affecting the prices we have to pay to buy goods and services we need.

Inflation refers to a persistent increase in the general price level of goods and services in an economy over a period of time. In other words during inflation times for the same amount of money we can buy less goods or we can also say that purchasing power of money reduces. The opposite process called deflation when prices are decreasing and the money's purchasing power increases.

Inflation

Rising inflation is something that people don't usually like to hear about. However in many developed countries today the low inflation is considered as an economic problem. I'm writing these words 2 days before ECB meeting where the president Mario Draghi will certainly try to suggest additional tools to fight "too low" euro zone's inflation. Something is wrong here, isn't it? Indeed inflation is quite complex phenomenon. Unlike deflation, which is almost always bad, inflation can be either bad or good depending on its pace.

As long as inflation refers to the higher prices it means that profits of the corporations increase, so they hire more workers, this sends wages up, so people can afford more goods, so demand increases, and the prices keep going up. This sequence sounds good, isn't it? Indeed inflation around 2%-3% is a characteristic if a healthy growing economy. The key point in the sequence presented above is wages that are supposed to go up a long with prices. If it is not the case inflation can become dangerous and in some extreme cases can cause an economic collapse.

One of types of dangerous inflation is hyperinflation when general price level within an economy increases rapidly as the currency quickly loses real value. Meanwhile, the real value of goods generally stays the same, and remain relatively stable in terms of foreign currencies. In such conditions usually the wages are not following the pace of the price rising and people can afford less and less of goods.

Another a bit less dangerous type of inflation is a stagflation. This is a situation when the inflation rate is high, the economic growth rate slows down, and unemployment remains steadily high. This situation is difficult to deal with as the governments are usually facing a dilemma for economic policy since actions designed to lower inflation may exacerbate unemployment, and vice versa.

Deflation

We are not talking very often about deflation but this is a natural economic process going closely along with progress. Indeed as technology improves we are now able to produce things cheaper and quicker, a lot of jobs were moved to Asia bringing production costs lower etc. So deflation is something constantly happening in the economy. But we don't really see prices falling. Indeed in the most common scenario deflation is offset by inflation. In other words these are parallel mutually compounding processes where inflation usually winning.
Why deflation is dangerous?

It sounds like a good news that things are becoming cheaper. But unfortunately these good news are hiding much worse consequences. As explained earlier, dynamic economy is likely to produce some inflation. If this healthy inflation is unable to offset deflation it means that country's economy is likely to slow down and probably there is a risk of recession. But probably even more dangerous effect of the deflation is an increase of the debt. Indeed in the developed countries both governments and households are heavily indebted and when money becomes more expensive then your net debt increases as well. This scenario is unacceptable for most of governments especially the United States having a huge debt.
Why deflation is unlikely?

As we are not living in the gold standard era, the purchasing power of the currencies can be easily manipulated by central banks and governments. As long as government doesn't want to see its debt rising it will always act whenever a risk of deflation appears. Indeed central banks usually have a monopoly on printing currency and increasing/decreasing money supply. So they are armed enough to fight deflation if needed.

Central Banks regulation and Interest Rates

Very often in financial media we hear people talking about Central Bank bringing Interest Rates higher or lower and the impact of these rates on the broad economy, mortgage rates, consumer loans etc. Let's look deeper into macro interest rates to better understand how do they affect our day to day life and the real economic sectors. Let's take a typical statement that we can come across reading through WSJ pages: "FED cuts rates by 0.25 point to reach record low of 0.50%". What does it mean? It may seem confusing as if tomorrow you would go to your local bank to apply for a mortgage your rates will be much higher. Let's try to understand what really happens and why this difference exists.

Government bonds

Bond Price vs Interest Rate

Governments to satisfy their budget needs as social security, defense, education etc. collect taxes and other state revenues which are usually not enough to cover all liabilities so they have to borrow money from investors. For that they issue Government Bonds with various maturities. In the United States they are called T-Bonds (Treasuries), in France - OAT, in Germany - Bunds etc. Bonds issued by highly rated countries are considered as an ultra-safe investment and their interest rates are close to risk-free rates. Government bonds are debt securities and are traded on the market. When any bond is traded it has a market price and interest rate. Both are linearly correlated, so when bond's price is going up the interest rate goes down. Therefore to bring the interest rate lower we need just start buying more bonds on the market increasing demand. To bring the rate lower we would obviously do the opposite it means sell bonds on the market. This is standard supply and demand rule. Remember well this relationship as it will be important later for understanding this article!

Commercial Banks

Walking down your city center you will certainly see several cash machines of well known local banks. Depending on the country you are living in examples can be City Group, Wells Fargo, Bank of America, HSBC, Barclays, BNP Paribas, Société Générale etc. All these banks are Commercial Banks operating in your country. Their traditional business is to finance individuals and corporations. To achieve this goal they are taking deposits from ones to give loans to others. Commercial bank lends money to an individual or corporation for a fixed or floating rate. In both cases this rate will be negotiated between the bank and its client within some interval of rates proposed by this concrete bank. Without going into details I'll just say that rate will be indirectly correlated to the current government bonds rate. It doesn't mean that it will be equal or close to this rate but when government bond rate increases the commercial bank's rates will increase too. I'll write an article explaining this relationship later.

Central Bank

Central Bank is a special type of bank that can be seen as a "bank of the banks". This definition may appear confusing as central bank's role goes far beyond of taking deposits and lending money out. Firstly central bank is an institution that manages a country's money supply, oversees the commercial banking system and acts as a lender of last resort to the commercial banks during financial crisis. As long as central bank possesses a monopoly of printing national currency its financing capacities are by definition unlimited. Thus the bankruptcy of the central bank is structurally impossible. In the most of developed countries the governments are controlling their central banks. The exception is United States where central bank (or Federal Reserve or FED) is a private company with a secret list of shareholders and the president of the bank is appointed by the president of the United States. In my opinion the word "bank" isn't applicable to the concept of the "central bank", as its primary role is regulation and not financing. Indeed it fulfills its financial role only in critical situations when regulation did not work properly.

Central Bank's regulation

As mentioned earlier one of the key roles of the central bank is to manage money supply. Money supply doesn't necessary mean "printing money" but more generally it refers to the amount of money available to the economy or amount of money available to the commercial banks financing this economy (individuals and corporations).

Typically central bank can increase money supply when GDP growth is slowing down, interest rates are too high, inflation is lower than its target level (creating a risk of deflation) or when currency rate is considered as unacceptable. On the other hand it can decrease money supply when there is a risk of a bubble on the real estate and/or capital market, interest rates are too low, inflation is far above its target level and/or again currency rates are considered unsatisfactory.

To regulate money supply central bank basically has 2 options:

1. Alter the reserve requirement.
2. Influence current interest rates on the market using OMO.

Reserve Requirement

Commercial banking system is very important and a bankruptcy of a significant commercial bank can have substantial consequences for the broad financial system. This is where central bank comes into play. To accomplish its regulatory role the central bank sets reserve requirement. Reserve requirement is an amount of capital that commercial banks have to put aside for each loan they are lending out. The required reserve ratio is sometimes used as a tool in monetary policy, influencing the country's money supply by changing the amount of funds available for commercial banks to make loans with.



Example:
Bank of America (BoA) lends out 100 000 USD and the reserve requirement set by the FED is of 10%, then 10 000 USD must be put to reserves and cannot be used for other loans. This amount can either be kept as cash or deposited to central bank.

Scenario 1: Increase reserve requirement to bring rates higher
FED brings reserve requirement to 20%. BoA would put 20 000$ aside for the same loan and this amount would "sleep" on the central bank's deposits producing a tiny interest rate. So BoA would have less money to lend out. As long as the reserve requirement affects all commercial banks then there will be less money available to the broad economy financed by these banks. When money supply decreases and the demand remain constant then, following supply and demand rule, the "price of money" will be higher. The "price of money" is Interest Rate. The objective of the central bank is achieved!
Scenario 2: Decrease reserve requirement to bring rates lower
FED brings reserve requirement to 5%. BoA would put only 5 000$ aside for the same loan. So BoA would have more money available to lend out. As consequence the broad economy would have more capital available too. When money supply increases and the demand remain constant then, following supply and demand rule, the "price of money" or Interest Rates will be lower. The objective of the central bank is achieved!

NOTE: Western central banks rarely alter the reserve requirements because it would cause immediate liquidity problems for banks with low excess reserves. They generally prefer to use Open Market Operations (buying and selling government-issued bonds) to implement their monetary policy (see below).

Open Market Operation (OMO)

Another option to alter money supply will be direct government bonds market intervention in order to technically affect the supply and demand. As mentioned earlier the rates paid on the government bonds indirectly affect loan rates proposed by commercial banks.

Scenario 1: Bring Interest Rates lower

Central bank will start buying government bonds on the market (probably with newly printed money if it wants to increase money in circulation) bringing the prices higher. As discussed earlier higher bond price means lower rate. The objective of the central bank is achieved!

Scenario 2: Bring Interest Rates higher

Just the opposite, central bank will start selling government bonds on the market bringing the prices lower and rates higher. The objective of the central bank is achieved!

CONCLUSION

Let's return to our original question what means the statement "FED cuts rates by 0.25 point to reach record low of 0.50%"? Usually the matter concerns target rate. Paradoxically this rate is the most often mentioned in the media but it is the less meaningful. Basically it refers to the rate to which the central bank will "push" short term government bonds on the market. We can also translate this statement that central bank is planning to increase money supply or inject liquidity.

Important to understand that such a statement doesn't mean that all commercial banks will now borrow money at central bank itself for a lower rate but that only means the intention of the central bank to push down interest rates proposed by commercial banks.