Trader’s Narrative

I’m a bit surprised that there isn’t more discussion regarding the impending elimination of margin rules under Regulation T. This has massive implications for not only how the market will work in the future but also its direction.

The rules under which margin or credit is currently extended by brokers to their clients has been in effect since the outrage that followed the crash of 1929. Regulation T, instated by the Federal Reserve, applies a fixed rate of margin (50%) to securities accounts. And although it is among the 3 mechanisms by which the Federal Reserve can manipulate the amount of liquidity in the financial markets, it has never really been used. The most famous example of it not being implemented was in the late 1990’s when Greenspan repeatedly refused to up this rate to dampen the ‘exuberant enthusiasm’ taking the Nasdaq parabolic.

This rule will be replaced by an alternative system, initially suggested by the NYSE and approved by the SEC. Known as ‘Portfolio Margining’, it is primarily motivated by the NYSE’s battle against an eroding market share in the international financial markets arena. The new system is a stark contrast to the simple fixed rate of the old, being a rather complex calculation that takes into account hedging and offsetting positions between any number of financial instruments including: all margin eligible securities, listed equity options, listed equity futures contracts, and OTC derivatives on equities. As IB puts it, with “Portfolio Margin, margin is based on the largest potential loss found by valuing the portfolio over a range of underlying prices and implied volatilities.”

Don’t quote me on this but depending on the situation and portfolio, I’ve heard reports that a large hedge fund will find itself able to increase its leverage anywhere from 2-10 times more than before. And for retail clients, here is a brief example offered by ‘mskl’ on elitetrader.com:

In one of my accounts I mainly have Conversions/Reconversions.

My current Reg-T margin requirement is over $350 K. With Portfolio Margin - I will be charged the minimum per option contract (about 600 options X 37.50) or $22,250 - no direction risk or volatility risk

A Micro Example:

Long 1,000 shares of IBM at $104

Short 10 APR $100 Calls
Long 10 APR $100 Puts

Under Reg-t - My Margin requirement would be $52,000. Under Portfolio Margin the requirement would be the minimum or $750 (20 contacts x $37.50) a decrease of almost 99%

Not every broker will be offering the application of the new rules immediately and not every broker that applies it will do so equally to all their retail accounts. So call your broker up and ask them for details. I know that my broker, Interactive Brokers, will be offering the new rules on April 2nd 2007 - the same day they become effective. But only for accounts that have $100,000 US or more in Net Liquidation Value and apply for a “Portfolio Margin upgrade”.

I don’t think it is difficult to imagine the consequences of such a rule change. The financial markets are extremely complicated though, so I have no idea whether the Federal Reserve (or the PPT) will be monitoring this and extracting a commensurate amount of liquidity as an offet. Also, this new rule has been in the works for sime time, so the market has had ample time to digest and adjust itself ahead of time. I still see it as a positive for the market (long term) but only one of many cross-currents.

Clients of Interactive Brokers can find more information here about the new ‘Porfolio Margining’ rules and how they are calculated. And here, you can find a Deloitte brief titled: “Historic Change in the Leveraging of Securities Purchasing: The Advent of Portfolio Margining” (pdf).

On a totally different note, if you have a trading blog, don’t miss my first trading blog contest!