The following article was written by Jeff Wilkins, Managing Director, IS Risk Analytics.
Recent unprecedented volatility in the oil markets has created a risk dynamic which, if not addressed, could be catastrophic for brokers – negative pricing.
Heading into the expiration of the May 2020 WTI future contract, prices fell deep into negative territory due to a combination of lack of demand and lack of storage capacity. Following the move, Interactive Brokers announced it had suffered a provisional loss of $88 million due to client losses exceeding the equity in their accounts. They were clearly not the only firm affected.
Navigating unchartered territory can be a challenge, but this is where experience is incredibly important. In any market condition, traders are looking for an edge. As we move toward the settlement of the June contract, brokers need to be prepared in case a similar situation occurs, particularly because some predatory clients are seeking to exploit the situation. At low oil prices, clients can load into positions representing large quantities of the commodity, even with very little equity in their accounts. This presents risks to brokers on more than one front.
Firstly, clients often do this knowing that they are protected should their account reach a negative balance; either because the protection is mandated by regulators or knowing the difficulty brokers have collecting on negative balances. This gives the client a nearly risk-free trade with a large downside to the broker who still needs to honor the losses in their Liquidity Provider accounts.
Secondly, there are technology issues with many of the most popular retail trading platforms that prevent negative prices from being processed. This leaves brokers in a situation where client losses may be capped at a zero price, while their trades with their Liquidity Providers are filled at the correct negative rates.
MT4, for example, is not able to handle negative rates so should the oil price go below zero again then the system will stop pricing there, with the broker’s hedge trades being filled at well below this level. If we take an example of a -$20 USD price, this represents a $20 USD loss per barrel or, $2,000 USD per CFD contract. These losses can mount very quickly.
For a trader with a broker who cannot print negative prices due to platform limitations such as those above, the current environment presents a low risk option with substantial upside for a trader, leaving the broker holding a tremendous amount of risk. This risk cannot be managed using traditional means such as A book and B book.
With all this in mind, brokers need to protect themselves as much as possible in order to prevent what could amount to crippling losses. This may include increasing client margin requirements to at least as high as the amount the broker is required to hold in their own liquidity accounts. Additionally, capping the size of client positions can help prevent overexposure to such an event. There are other solutions that we are working on with our customers – for example, IS Prime has launched UK and US Oil Index products rebased at $100 to combat the huge risk associated with the spot oil price potentially going negative again.
While no one can be certain this month’s situation will repeat in May and beyond, every broker must take the steps necessary to make sure that in the event it does, it will not result in catastrophic losses for their firm.