The CME Vulnerability

The following sections are included:

• Preface — The Fundamental Challenge Caused by CME’s Negative Trading Price for WTI Oil Future
• About the Editor
• About the Contributors
• Contents

The following sections are included:

• Executive Summary
• Introduction
• CME’s Designated Roles, Responsibilities, and Liabilities
• WTI Crude Oil Futures and the COVID-19 Pandemic
• Analyze the Epic Meltdown of WTI Crude Oil Futures from Pricing and Trading Perspectives
• Passive Investment ETF and WTI Crude Oil Futures
• Conclusion
• References

The event of Chicago Mercantile Exchange’s (CME) negative oil clearing price on April 20, 2020, in which commodity futures traded in a negative range, is significant to the financial community worldwide. Through discussions of the so-called “best practice” rule for professional behaviors in practice with a number of examples and standards established by professional organizations, it seems that a better option for CME’s execution would have been to first seek feedback from stakeholders internationally within a reasonable transition period before implementing the proposed new trading (or updating) rule that came into effect in the month of April 2020.

This chapter briefly discusses the impact of the recent negative West Texas Intermediate (WTI) oil price incident on the fundamental relationships between WTI futures and spot prices, options pricing, risk measuring, hedging strategy, and regulatory rules. It emphasizes the importance of promoting best practice in oil price-discovery, the robustness of valuation, risk modeling, and system development with improved rules and processes.

The fall of crude oil futures into extreme negative prices has raised concerns globally. On the one hand, although the negative price mechanism facilitates market price discovery to some extent, in the delivery month it can trigger serious consequences such as abnormal market price fluctuations due to insufficient liquidity, which creates extreme market injustice and raises suspicion of manipulation. On the other hand, the reckless change of programs, which allow negative prices, lacks necessary legitimacy at the procedural level. Market participants who have been treated unfairly should actively defend their rights, and United States regulators and the Chicago Mercantile Exchange Group Inc. (CME) should explain to the market with thorough investigations and credible conclusions. The negative oil price incident is a profound warning and lesson for financial institutions and regulators in China.

We provide a game-theoretical explanation to the negative prices event of WTI2005 on April 20, 2020, in the context of a battery of economic phenomena. First, in the wake of the petropolitical maneuvering among several of the largest oil producers and the outbreak of the COVID-19 pandemic over the world, the global oversupply has caused tremendous pressure on oil prices. Second, speculative activities and the physical delivery mechanism led to a significant long-short imbalance, especially as the Cushing storage was reaching its capacity. Third, the Chicago Mercantile Exchange’s (CME) introducing of the negative price scheme stimulated strategic interactions among futures traders. The negative prices were triggered by the existing long buyers, while their counterparties showed little resistance, reflecting the fact that the market was vulnerable and highly susceptible to manipulation, and some active long/short investors may form a coalition to exploit the specific trader(s).

On April 20, 2020, the West Texas Intermediate crude oil futures contracts for May were traded at as low as $–40.32 per barrel on the Chicago Mercantile Exchange. This was a very unusual mispricing. First, the mismatch between supply and demand had caused a slump in oil prices. Second, the rise in oil storage led to increased cost of inventory and shipping, which had further impact on oil prices. Third, the trading principles and features of oil futures on exchanges triggered the mispricing of crude oil futures. However, when faced with such huge mispricing, arbitragers did not take the arbitrage opportunity initially due to constraints of holding tankers or tankships. Retrospectively, arbitragers did take action, but with a one-day delay. The post-event performance of the shipping market indicates that holding tankships is of vital importance in the arbitrage of crude oil mispricing.

Fischer Black and Myron Scholes (1973) assumed asset prices follow lognormal distributions and derived the famous Black–Scholes option pricing formula. The lognormal assumption implies the asset price will never be negative and has zero as its lower bound. By relaxing the negative and zero bound, we derive a Black–Scholes-like option pricing formula for asset prices following a shifted lognormal distribution with a lower bound. The formula can be applied to price options with negative prices and negative strikes.

2020 is definitely a year that will be remembered in history. The global outbreak of the COVID-19 pandemic has caused a huge impact on the global economy, in particular, the paradox of negative oil prices, which has raised huge challenges in the practice of commodity and related asset risk management.

The oil future’s precipitous drop to the negative range on April 20, 2020 stunned and confounded many industry professionals and academics. It also posed a great challenge to risk managers and financial engineers responsible for the appropriate models for pricing and risk measurement. This chapter provides an extensive discussion about the rationale and mechanism behind the negative price as well as the related modeling issues. We generalized the situations and scenarios under which negative prices are economically reasonable; examples from past experiences in different markets in the world were discussed. Model choice in handling negative commodity price was discussed. Our analysis and simulation cast doubts on the appropriateness of the Bachelier option model the Chicago Mercantile Exchange (CME) hastily switched to before the big plunge. Specifically, we introduced the hyperbolic sine transformation method, whose output is amenable to the Vascecik model, as a viable alternative to the Bachelier model, and demonstrated its applicability in modeling negative oil price.

We discuss the Fundamental Theorem of Asset Pricing (FTAP) in a model-free discrete time setting to emphasize the credit constraints. Negative asset pricing breaks the credit limitations to collapse the FTAP. The credit constraints and moral hazard are not only for market buyers and sellers, but also for market makers.

On April 20, for the first time in history, a major oil future, West Texas Intermediate (WTI) May contract, closed below zero, raising alerts among market participants and regulators on the real possibility of negative prices, which is not a standard assumption when pricing derivatives outside the fixed income market. Following the event, the Chicago Mercantile Exchange (CME) announced that the Bachelier model would be used instead of the standard Black–Scholes model accounting for pricing negative strike options. In this paper, we first compare the two models and highlight their key technical differences; then we present the potential implications caused by model switching on derivatives pricing, risk management, and market structure from a practitioner’s point of view; lastly, we discuss some practical points the regulator should be noting when considering to modify the current regulatory framework.

On April 20, the negative price in the last trading session of the Chicago Mercantile Exchange (CME) West Texas Intermediate (WTI) oil futures shocked many traders and investors globally. It caused much potential risk exposure for commodity futures trading and impacted pricing and valuation models in many derivatives. One of the essential hidden risks of commodity futures exposed by this event is high storage and delivery cost of their physical settlement, which reduces the hedging functionality of commodity futures during high volatile market periods, such as the coronavirus (COVID-19) pandemic. This chapter proposes options to hedge the risk by the fluctuation of physical settlement cost. Since both listed and over-the-counter (OTC) options may take a long time to be issued in the market, we propose to use blockchain technology to issue physical settlement rights by tokens. The transportation and storage provider can make profits by this covered-call like options strategies. At the same time, commodity futures traders can get proper insurance for this kind of recent unexpected risk for sky-rocketing high physical delivery cost. Blockchain technologies such as smart contract and decentralized settlement system can be more flexible to offer these options rather than traditional derivatives exchanges. And the premium can be paid by the commodity itself to the transportation and storage provider to link token value closely to physical goods and reduce inflation caused by currency over-issue. The simulation and scenario analysis are done to demonstrate the risk hedge functionality of these options for the April 20 event. And we show that based on economic theory, the combined price of commodity futures and its physical settlement options should be larger than zero if the economics is to keep moving forward.