Systemic Risk Rears Its Head

“If you owe the bank $100 that’s your problem. If you owe the bank $100 million, that’s the bank’s problem.” – J. Paul Getty

This famous quote, the spirit of which predates Mr. Getty, has been flipped on its head. We now see that it is similarly problematic when a million people each owe the bank $100 when it’s all backed by the same volatile collateral.

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There is something important to remember about the brokerage industry – a clearing broker is exposed to movements in its customers’ holdings. This is not about proprietary trading, by the way. 

When a broker lends a customer money to buy a stock on margin, it makes a loan collateralized by the stock itself. SEC rules state that broker is required to lend no more than 50% of the initial purchase, and require that a customer maintain at least 25% of the current value of the security as funds in the account. These are minimums, and the individual broker can impose more stringent requirements than those statutory requirements.

Ask yourself what happens to a broker if the value of the collateral moves by 50% or more. At that point, the shares that are held as collateral are no longer sufficient to collateralize the loan. That means that the collateralized loan has effectively become uncollateralized. There is now a significant risk to a broker that it can’t be paid back by its customers.

Brokers are also exposed to their customers who short stocks. In a short sale – which is both legal and ethical – a broker borrows shares that it delivers on behalf of the short-selling customer. The broker has effectively taken out a loan of its customer’s behalf, collateralized by the proceeds of the short sale. The customer now has a liability to buy back the shares, hopefully at a lower price. If the stock rises so far that the customer can no longer afford to buy back the shares, the liability passes to the broker. In the case of stocks that have sequential double or triple-digit percentage rises, that becomes an immediate problem.

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Trading on margin is only for sophisticated investors with high risk tolerance. You may lose more than your initial investment.

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