What Is Hardening?
Hardening is a reference to trading conditions in which securities prices are rising and volatility is declining in a particular financial market. Although the assessment that a market is hardening can be applied in several contexts, it is most commonly used when referring to the market for commodities futures.
The term hardening can also be used in the insurance and banking industries to refer to a period of more stringent underwriting or lending standards.
- In the finance industry, the term “hardening” is typically used to refer to a period of rising prices and reduced volatility, specifically in the commodities trading industry.
- The term hardening is also common in the insurance and lending industries, where it refers to periods of time when more rigorous underwriting or lending practices are implemented.
- In the banking and insurance industries, hardening is often observed in the aftermath of financial crises when financial institutions are more eager to control and reduce their risks.
How Hardening Works
In commodities trading, a market is said to be “hardening” if its prices are steadily rising at a time when volatility is relatively low. For many traders, a market that is hardening presents ideal conditions for trading because of the apparently calm and predictable nature of the market at such times.
Of course, for traders wishing to speculate on large movements in commodity prices, a hardening market might be a negative sign, as the resulting decline in volatility could make those large moves less likely to materialize. This could be especially damaging for owners of options contracts set against those commodities, whose value generally falls when the volatility of their underlying asset decreases.
While hardening is most often noted in reference to the trading conditions of commodities futures markets, it is also used to refer to periods of strict underwriting or lending standards in the insurance and banking industries.
How Speculators Impact Volatility
A commonly held belief is that the rise of speculators into the commodities futures markets has led to an increase in price volatility on futures contracts. On the contrary, some researchers have concluded that an influx of futures traders, and the liquidity that they bring to the market, have a stabilizing or hardening effect on futures prices.
These researchers suggest that futures markets are considered volatile not because of price fluctuations, but because of a great deal of leverage available to futures traders. By way of example, equity margin requirements are generally around 50%, whereas margins as low as 5% to 10% are common for futures contracts. Under these circumstances, even small fluctuations in price can have a tremendous impact on the owner of a highly leveraged futures position.
When applied in the insurance and banking industries, the term hardening has a different meaning. In these industries, hardening is commonly used to refer to periods of more rigorous underwriting or lending standards. These periods often arise following a financial shock such as the credit crunch that occurred during the 2007-2008 financial crisis.
More rigorous underwriting or lending practices are sometimes implemented in response to risky decisions by the financial institutions involved, such as the optimistic derivative contracts and subprime loan agreements that American banks and insurance companies entered into prior to the 2007-2008 financial crisis. In the aftermath of this financial crisis, financial firms were keener to reset their lending and underwriting standards on a more conservative footing.
Although this reversal in sentiment amongst financial institutions–from risky to more conservative–can help reduce the incidence of inappropriate insurance policies and too risky loans, it can also make it difficult for creditworthy counterparties to secure credit or insurance. In these periods of fiscal “hardening," consumers and market participants alike will often complain that approval criteria have become unnecessarily onerous.