The future is uncertain, and those who plan on devoting significant time and energy in producing goods have always been concerned that the fruits of their labor may wither on the vine before they go to market. Archaeologists have uncovered several clay tablets from ancient Babylonia (circa 1,400 B.C.) used as contracts to protect or hedge against these concerns in ways very similar to modern financial forward contracts. The tablets contained stipulations on the quantity of grains the seller of the contract would deliver on a future date and the fixed price agreed upon at the time of contract. There is some evidence that these contracts could even be transferred to third-parties after initiation. Thus, Mesopotamian farmers could introduce some stability to their harvests and help plan to meet the needs of the growing city-states in the region.
As time went on and civilization progressed, the need for more sophisticated financial protections for fundamental goods became evident. Commodities exchanges were developed that offered standardized future contracts for standardized amounts of fundamental goods, to be delivered to standardized locations, with standardized credit terms for buyers and sellers, having the exchange as the counterparty in every transaction. This standardization supplied by institutions like the London Metal Exchange (created in 1877) helped to provide liquidity and transparency to the markets they serviced and allowed for a more thorough price discovery of the underlying commodity.
Producers of industrial metals like nickel, which is used to make stainless steel and electric car batteries, could now reduce the volatility in their revenues by shorting futures contracts on the exchange. If the price of nickel went down, the short future contacts would go up in value; if the price of nickel went up, the short future contracts would go down in value. The counteracting instruments should produce a more stable cash flow for nickel producers. However, in order to safeguard the stability of the futures contracts market, the exchange requires participants to make a deposit to ensure they can meet their obligations as spelled out in the contract. This deposit or “margin requirement” changes as the value of the position changes, with adverse price movements causing the exchange to issue a margin call to demand more money to ensure that contract is still likely to be fulfilled. Thus, a sudden increase in nickel prices, while a long-term boon to nickel producers, could produce short-term financing issues with margin calls.
Now, Russia was the world’s third-largest producer of nickel and its largest exporter of refined nickel metal—the specific type used in London Metal Exchange futures contracts—until it invaded Ukraine in February. The international sanctions imposed in March led to concerns about sharp reductions in nickel supplies, causing futures prices to skyrocket 250% from March 4th to March 8th. Producers of nickel that had significant short positions, specifically China’s Tshingshan Holding Group Co., the world’s largest nickel producer, faced intra-day margin calls beyond their means to finance. The sharp spike in prices helped produce a short squeeze in the market where some traders closed out their short positions quickly to cut their losses, pushing the price up further and exacerbating the margin requirements for the remaining short positions. The unusual event had put the London Metal Exchange, an institution established to facilitate commerce in metals, in a position where its rules to stabilize the market could potentially bankrupt the major suppliers of nickel. In response, the exchange halted trading on Tuesday, March 8th, and made the controversial move of canceling all trades that took place that morning. The nickel exchange was closed for a week and has been beset by computer glitches and shortened trading sessions as it has attempted to gradually bring stability back to the price of nickel. The whole episode reminds us that all financial systems are works-in-progress and that even the most efficient man-made structures can break down in extreme, unexpected situations.
Performance is no guarantee of future results. Trend signals are proprietary research of EWM Investment Solutions, a wholly owned subsidiary of Executive Wealth Management, LLC. Data source for returns is FactSet Research Systems Inc. This chart is not intended to provide investment advice and should not be considered as a recommendation. One cannot invest directly in an index. Executive Wealth Management does not guarantee the accuracy of this data.
Model Updates
On Tuesday March 15th, the EWM Investment Solutions Focused Income model added a new fund to its lineup designed to provide monthly dividend income distributions with a reduced exposure to equity volatility. There were no other trades in the EWM Investment Solutions models during the week ending on March 19th, 2022, with domestic equity market sectors still maintaining their long-term favorable trend.
Quote of the Week
The problem with betting on disaster is that when you win there has been a disaster.
Bloomberg Opinion columnist Matt Levine commented last week on the difficulties some traders have had in closing their short positions on Russian stocks following the invasion of Ukraine and the subsequent shutdown of the Moscow StockExchange. In order to close a short position, a trader must return the shares he initially borrowed to sell short, but if shares are not available because a country’s stocks have stopped trading due to war and sanctions, then the trader is trapped paying borrowing costs for an item that he can’t possibly return.
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Returns are calculated as indicated below with reinvested dividends not considered except for the Barclays U.S. Aggregate Bond Index. Data source for returns is FactSet Research Systems Inc. The London Gold PM Fix Price is used to calculate returns for gold.
1 Week = closing price on March 11, 2022 to closing price on March 18, 2022
1 Month = closing price on February 18, 2022 to closing price on March 18, 2022
3 Month = closing price on December 17, 2021 to closing price on March 18, 2022
YTD = closing price on December 31, 2021 to closing price on March 18, 2022
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