Client leverage growth is a potential risk

This year, client margin debt has declined as markets weaken and economic uncertainty increases. Jack Rando, chief executive of the Investment Industry Association of Canada (IIAC), said forthcoming data will show outstanding margin debt had fallen to $37.2 billion by the end of the second quarter. quarter, compared to $38.4 billion in the previous quarter.

However, client indebtedness remains well above pre-pandemic levels at a time of rapidly rising interest rates. National Bank Financial Inc. has estimated that rising rates will add $30.4 billion to household borrowing costs over the next two years, including about $14.0 billion from more expensive lines of credit and the rest coming from higher mortgage expenses.

Higher borrowing costs are only part of the risk. Asset price volatility associated with leverage also increases the risk of severe market turbulence. Falling asset values ​​that trigger margin calls can create a “margin spiral” – a negative feedback loop when investors are forced to sell in a falling market, causing values ​​to fall further.

In an extreme scenario, the financial system as a whole is destabilized, putting the balance sheets of banks and stockbrokers under pressure as these firms seek to absorb selling activity. Markets faced this kind of turmoil when the Covid-19 pandemic first hit, triggering widespread selling. This prompted policymakers to take unprecedented steps to bolster market liquidity by cutting interest rates, buying assets and easing capital requirements.

Since then, the collapse of New York-based hedge fund Archegos Capital Management LP has exposed another risk: the threat of undetected buildups of leverage. In March 2021, Archegos collapsed after the firm was unable to meet margin calls on its highly leveraged and highly concentrated trading positions. The banks suffered billions of dollars in losses when the company went bankrupt.

“The collapse of Archegos has shown how the risks associated with leverage, concentration and interconnection can crystallize”, noted a post-mortem on the fall of the company by the European Authority. of the financial markets published in mid-May. “Beyond the overall losses suffered by some banks, this event indicates that further work is needed to adequately monitor derivatives and leverage risks.”

The Bank of Canada’s latest Financial System Review stated that “if left unchecked, positions built through ‘hidden leverage’ can become large enough to harm financial stability, especially if combined concentrated credit exposure of lenders to highly indebted companies. »

Given the concern, the central bank is participating in efforts by the Financial Stability Board (FSB) to better understand the sources of hidden leverage globally. The FSB is expected to report its findings to the G20 in October.

Meanwhile, the recent growth in client margin debt in the Canadian investment industry is no secret. The sharp rise in margin debt from its first-quarter 2020 level to its late-2021 peak (a 69.4% jump) occurred amid favorable investor borrowing conditions and a boom in retail investment.

The Investment Industry Regulatory Organization of Canada reported that account opening activity more than doubled in 2020, with approximately 2.3 million brokerage accounts opened during the year, compared to less than 900,000 the previous year.

The surge in retail investor activity has led regulators to worry about the risks taken by novice investors, many of whom get their investment information from social media and other dubious sources.

In the wake of the retail surge, the Ombudsman for Banking Services and Investments (OBSI) has reported a sharp rise in complaints involving DIY investment firms in 2021. In particular, OBSI has found investors complaining of margin issues as well as service and order issues. execution problems.

OBSI also reported that service issues — such as an investor’s inability to access their account amid high trading volume and increased market volatility — can be exacerbated when that investor also faces calls. margins that threaten to decimate his portfolio. Yet investors who accept these risks when signing up for a DIY account may have little recourse when their securities are liquidated to meet margin calls.

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