Futures, FX and Crypto

On Monday 20 April 2020 the May contract for West Texas Intermediate crude oil, the most traded oil futures contract in the world, settled at minus $37.63 a barrel. The contract is physically delivered: a holder of a long position at expiry, the next day, must take 1,000 barrels a contract at Cushing, Oklahoma, or close the position before trading ends. That spring, lockdowns had cut oil demand faster than producers could cut supply, and the tanks at Cushing were filling. Holders of the expiring contract who had no storage, funds, retail products and individual traders who had bought "cheap" oil, had to sell to the few who could take delivery, and those buyers demanded to be paid to take it. Many retail buyers had assumed oil could not go below zero. So, in effect, had the models: option-pricing formulas of the Black–Scholes type take the logarithm of the price and cannot represent a negative one (companion's profile of CME Group).

The exchange had seen the problem coming. On 8 April CME Clearing had published a plan (advisory 20-152) to switch its energy options from the lognormal model to the Bachelier model, which assumes normally distributed price changes and comes from Louis Bachelier's thesis of 1900, if WTI futures fell to low levels; it told the market its systems could handle negative prices. On the day it did not halt trading or alter the settlement, and from 22 April it priced and margined WTI options with the Bachelier model (advisory 20-171). The clearing house worked as designed: no clearing member defaulted, and the long holders paid the shorts through variation margin. The losses fell on the longs and on the brokers whose customers could not pay. Interactive Brokers, whose software had assumed a floor at zero, reported an aggregate loss of about $104 million, about $103 million of it paid to compensate affected customers and about $3 million of customer bad debt (8-K, 21 July 2020). In China, retail investors in Bank of China's "Crude Oil Treasure" product took large losses (reported).

The day is the clearest lesson in this book that contract design and settlement mechanics are risk factors. Nothing about the oil itself had changed overnight. What had changed was the cost of honouring one contract's promise, delivery at a particular place on a particular day, for traders who had never intended to keep it.