May 28, 2020 In late April, the market was witness to an unprecedented event, negative oil prices. Such an event had never happened before in the history of trading oil futures contracts. Turnkey staff spent the last month speaking with our customers about this historic situation. We have spoken with FCM executives and risk managers, former energy floor traders, independent introducing brokers, and some of largest retail trading firms in the country. Our goal was to get a behind the scenes, firsthand look, at how the markets functioned during the price collapse. We also wanted to gauge public opinion surrounding the historic event to see if anyone had ideas about what could have been done differently. What follows are some of the questions we asked our customers along with the answers we received back from them: Questions Posed What types of customers/firms have you heard of or do you know that were most severely damaged when oil prices fell below zero? Were they retail traders? Were they commercial hedgers? Physical producers/suppliers? Funds and Institutions etc? What did you observe and see in the markets with respect to bids/offers at the time oil prices were negative? Could orders be executed? Were execution platforms working correctly? Was anything different with respect to market liquidity vs other periods of high volatility you’ve experienced? Fundamentally how has a negative price impacted your approach to handling margin? risk? trading decisions? How have exchanges responded? How are you modeling risk knowing that a long position may now lead to an unlimited loss? Have you found SPAN margin still makes sense with the possibility of negative prices? Would you point a finger at anyone, or any group, for what happened? Did the market function as it should have? Why? What articles should our staff read on this topic? What has been published on this event that you have found insightful? Can you think of any constructive changes you’d want to see as a result of this event? Interesting Responses Received Senior Executive Major FCM Small retail guys were hurt the worst Commercials got hurt but understood what was happening and why. Bonafide hedgers generally understand risk very well. Funds got hit hard if they were taking speculative positions assuming the bottom was in A lot of position traders with adequate margin simply got stuck with positions and couldn’t get out The rumor mill is suggesting banks have had and will have huge write offs ahead The negative pricing structure seemed to work on all execution systems; there was just no liquidity Margin has been heavily increased in front month contracts Have prohibited all retail trading in WTI and Brent for front month contracts. In many instances position rolls were forced from front month contracts into back dated contracts. We believe this event is unlikely to happen again. Historically the industry over reacts to the opposite direction in an event like this. The new controls in place across the industry are unlikely to allow people to get in trouble like they did any time in the near future. Exchanges should allow negative pricing to maintain the free market nature and concepts of trading. Additionally the market was demanding a negative price due to storage constraints and the fact that short orders were still coming in even at a zero bid. If there is one thing that we’d like to see changed is daily limits for all markets and contracts that are widely known. We believe that could have helped the market gain footing as it has in other settings. NYMEX energy floor trader I didn’t have experience with anyone in particular that lost badly. For us producers trading commercial probably were the biggest losers. Them or refiners. Clearing firms such as Interactive Brokers (see article below) with a lot of retail, independent traders, or those with poor risk management responses will probably fare the worst. When prices were under $10 there were basically no bids/offers, no liquidity what-so-ever. I recall that the only bids being hit were resting orders; panic selling started to occur as it does during periods like this. People were looking for any price to offload positions. I don’t personally think the SPAN system and margin structure worked in this event. Even with 100% margin obligations it wouldn’t have been enough to cover some of the debits I have heard of. Unfortunately I am not sure if any risk management or margin tool would have worked effectively under such conditions. Its possible that we could see the clearing house, or possibly the FCMs, start prop trading simply to manage customer position and concentration risks. I think you’ll see groups that will get hurt from this and start managing aggregate client book risk differently. An interesting thing that happened to us is that we received a dozen or so calls from people that wanted to buy crude. They felt that they had storage capacity to take delivery and over time would be able to profit. We couldn’t get much done because at the time the concept of margin on a negative asset was so odd. It wasn’t clear to anyone who had to pay margin or how delivery might work if the value of the underlying asset was negative. Heard a trader in Singapore had massive losses and hid other losses (subsequently came out this was true ) I don’t think pricing should have gone negative. It would be interesting to explore the legality of the contract specs at the creation of oil futures contracts. One thing I would want changed is that all markets should have daily price and contract limits. I think our industry has to have an adult conversation about what is allowable in all futures contract pricing. If we agree negative pricing is what should occur then that’s fine but it needs to be clear to all market participants well ahead of time. I think the issues surrounding this situation largely stem from a fundamental misunderstanding of how the futures markets work. I don’t think retail traders accessessing futures contracts via ETFs had a clue this could happen. Head of Risk Major FCM We’ve only really heard about major debtis that are uncovered at Interactive Brokers (see article below). We didn’t have very many problems and none of any significance to the FCM. When this occured the market got very wide and very illiquid. A broker we work with had a few orders that were not executed at any price even when placed at the market. Some of the industry platforms worked fine. Others I know did not plan for, or had not been developed to accept a negative integer for price. We have raised margins over exchange minimum for clients but felt our risk controls that were in place did a nice job so those are largely unchanged. We had no issues and have no issues with SPAN either I don’t think anyone is to blame so I would not point a finger. The stupid thing was traders buying into that type of a market downfall under those circumstances. The CME had put out a negative pricing release the prior day saying it was possible. That should have been enough for many people that got stuck in a trade to rethink what they were doing. Initially, I found it unusual and wrong that a negative price was allowed. It did seem to make some sense though — there’s such a glut in storage that you will be paid to take oil away. On the other hand that did not seem to work either. I was talking to a broker that worked with a very well connected and widely known Texan who threw in the towel. This person wanted to take delivery and had the capacity to do so. How things transpired, with the notice about negative pricing, it really was too short a time frame for them, let alone anyone less substantial in the space, to put it all together – at least that’s what they told me. In that regard, what we saw, was that really the only ones hurt were the mini crude longs. That part I find to be rather unfair – a cash settle of -$37. There was no pracitcal opportunity that came to the regular contract longs, like the Texan I mentioned, the next morning. (Keep in mind mini crude cash settles the day before the big contract). This industry is so overleveraged. Hopefully this will convince exchanges to raise margins and instill circuit breakers. Circuit breakers seem to work well, even recently with the stock market it’s been the circuit breakers that have saved people and allowed for cooler heads or market solutions to work out. I think crude should have circuit breakers too, it would give everyone time to reassess, the traders, the FCM’s looking at risk, and the exchanges. It would allow people like our Texan to figure out how to handle delivery properly. The whole thing was incredibly interesting thats for sure. Former Floor Trader & Large Independent IB The general decline in the oil market has had, and will have a profound effect on the markets in general. This comment is aside from the recent negative price activity. I think crude should be put into perspective. The price for whatever reason was held up, and way over valued, in my opinion, for the last 5 years even while record amounts of crude were being stored above ground. The average price of crude over the last 30-40 years is 18-24 $ per barrel. The reality is that the exchange, along with the regulatory bodies have allowed banks, ETFs, and larger institutions to take record positions. This was not always the case. A speculator was always held to a position limit. I don’t believe this is true for certain institutions or ETFs. Why? For me many futures markets are no longer tied to fundamentals. Typically, cash prices in grains are well above or below the futures price, same in meats. This should create a convergence between cash and futures. This isn’t typical any more. I think this is also why traders who are fundamentally or classically trained with long successful careers find it difficult, if not impossible, to navigate or manage risk in these markets. A lot of guys I know have just simply quit trying. With respect to the situation that occurred. The span models are functional only in a typical environment. However, in moves such as occurred they are rendered useless. The options specifically always deviate from a model when volatility explodes. I think the FCMs to a certain extent did a fine job in that regard given what they had to work with. I think many professional market participants were aware of the ability for prices to go negative. That represents the function of the market and free market thinking. I get when someone says “Here, I will essentially pay you to take this, I can’t physically store it”. It makes complete sense when thought of from that perspective. Like usual and as should happen commercial global players stepped in at the time when the market reached a point that they knew the product was at a price they could make work under the extreme circumstance. In my opinion the danger of this whole scenario is that the regulators or exchanges use this to step on smaller participants. I could see that happening under the guise of needing to “protect the public”. The real danger in the futures markets isn’t there. Rather it lies in the unbridled strength and limits (or lack thereof) put on large entities and ETFs. I personally think we’ll see more crazy price action like this in the future as traditional market structures and participants leave or are forced away from futures trading for hedge needs. Well Known Financial Industry Author/Professor Interesting question regarding negative pricing being allowed. It might be tempting to answer NO—the minimum price should be zero—consider the following situation, which is similar to what occurred. Let’s say that storage is so tight and limited capacity so expensive that there are not enough buyers at zero to clear the market. Then you effectively have the marked locked at zero with a surplus of sell orders. These sellers would then be stuck unable to offset their positions before expiration, which would be an even worse situation than negative prices to contend with. Large Independent Introducing Brokerage I know some FCMs took relatively large losses. Some had to have customers sign gaurantees on debits and set up payment plans. It seems interactive brokers took the most damage due to its retail book and some system issues at $88M (see article). Other FCM’s we work with seem to be stressed and do not want customers trading the front month oil contracts. They have raised margin in most cases 100% but in one case as much as 300% on these contracts. When prices collapsed the bid/offer spread got very wide if I remember correctly. We had a few customers trading one lots, fully margined at the start of the day, who ended up debit $4,000.00. Anyone with any size or undermargined accounts got hit pretty hard. We have asked our customers to not trade the front month which is in alignment with most of our FCMs. I personally think that a fully margined account should be able to trade however it wants under the correct risk controls. Just because we have losers doesn’t mean the market should stop functioning or we need to eliminate trading in a particular product all together – if we do that, what then? Span is good until it is not. Things like this have been happening to our industry for years. The exchanges always lower the margins as far as possible until everyone gets crushed with a big market move. By the time they increase the margins it hurts the guy trying to stay in the market to recoupe their losses from having too much exposure and it shakes people out permenantly. The silly part is that most of the time when exchanges raise margins the party is already over and risk controls have gotten so tight the volatility is unlikely to come back for the same reason. Ironically there is extreme volatility in how the market reacts to volatility that hurts people and might end them trading forever. I wouldn’t point any fingers, like I said I think markets should operate freely and a negative price makes sense in theory. I do however think that all markets should have limits set daily. From my perspective this has to happen to prevent customers from going broke in one trading session. After many years in this business people will never understand or get risk management fully right. Limits or circuit breakers might help people to learn lessons and make changes instead of just wiping them out. My only real issue is that I don’t think a lot of people really thought pricing could go negative. Again in theory it makes sense but I’ve been doing this for more than 20 years and had never seen it or really thought it could happen either. I am aware of a lot of oil companies that hedged that made crazy money on this move and were protected. I also know of a lot of oil companies that are going to close their doors. I think smart market participants in the oil business will see this as an opportunity to take over oil wells and other distribution as a long turn investment at a cheap price. Overall I don’t think this event was a good luck for our industry especially since it seems to have hurt mostly individual traders and ETF holders. Final Thoughts It appears by in large that the industry was generally accepting of negative oil prices. It is interesting to see how many market participants expressed a desire for more transparency from exchanges about the possibility of a negative contract price. Similarly almost everyone we spoke with (some not included within this article as well) shared that they’d like to see circuit breakers or daily limits in all futures contrac markets. If you’d like to read more about this historic event the following articles were shared with Turnkey’s staff. We’d encourage anyone interested to review them for more information about what occurred when Oil prices went negative: Reuters – Bank of China Settles Cases in Oil Product Losses Barrons – Oil Futures Unlikely to go Negative Again Podcast – Kaminski and Ronn on Negative Oil and Options Pricing Reuters – A Month After Negative Oil Prices in US Crude. Bloomberg – Oil Crash Busted Broker Computers Causing Millions in Losses If you like what you’ve read please contact Turnkey today to learn more about our services. We’d love to discuss how we might be able to assist you in meeting your CFTC and NFA regulatory or accounting obligations. Please call (312) 324-0040 or click here to contact us.