The Swiss franc blip: time FX leverage limits moved from flat percentage to risk-based?
The dust has settled from the initial fall out from retail brokerages going out of business as a result of the Swiss National Bank's abrupt removal of the CHF vs EUR peg several weeks ago.
So I think it's time to ask a deeper question - does it make sense to use risk-based margins in retail FX proprietary trading? After a quick review I can't see a good reason why not.
The initial response
For a short period it was common to see reports of retail brokerages going out of business or suddenly changing margin levels. FXCM in the US, Alpari in the UK and Global Brokers NZ of New Zealand are just a few of the names in severe difficulties or out of business altogether. Some brokers (including Lukascopy and FXPro are already increasing minimum margins to 10% or 10:1 leverage instead of the prior 2% or 50:1 leverage minimum (according to this article from Leaprate). In particular broker IG is causing a stir by increasing it's margins on pegged or controlled currencies and stop loss positions according to this Reuters UK article - indicatively up to the 30% in some cases.
So far regulators are monitoring the situation and the NFA has temporarily increased the US minimum FX margin from 2% to 5% with CFTC and FCA among others keeping a watching brief. As background there was a prior effort in 2010 to increase minimum margin to 10% which didn't not go through and recently there was even some noise that 2% was over the top (see e.g. this WSJ article (subs required)).
Why did the brokers go out of business? The speed of the move compared to client margin levels
Whilst minimum margins are agreed at the discretion of the client and the broker and this could in theory encompass a risk-based assessment of both the client and the market, in practice they can be as low as 2% and it may be that this has become the norm in a "race to the bottom" of brokers.
If the SNB had "guided" the market on the move in advance there may have been more days and more margin calls or position close outs to absorb it. As it was they did not and the one-day appreciation of CHF vs EUR and USD of 18+% (source: oanda.com) any participant with significant CHF exposure as a proportion of the total FX exposure in their account would have burned quickly through their margin. For the good of the market, brokers are on the hook to make up the difference to the extent additional intraday margin calls to clients were not met. (So FX brokers are a bit like FCMs in guaranteeing the performance of their clients to the market).
Free market Idealogues will no doubt seize the moment to trumpet the futility of central bank intervention. Putting that on one side what is clearly empirically evident is that it doesn't always work and that central bank resources are ultimately limited and cannot be fully relied upon.
Whilst the speed and size of the move was surprising it is relatively common to see significant shifts in FX values. In fact according to OANDA.COM historic FX rates, 9 times in the past 5 years there has been a 1-day CHF vs EUR move greater than 2%. And 26 times in the past 5 years there has been a 2-day CHF vs EUR move greater than 2%.
Given no tangible value how a flat percentage work well?
No doubt some are comparing 2% FX minimum margins to the US reg T minimum of 50% but that misses the point that - unlike securities and commodities which are underpinned by tangible assets / defined cash flows - FX is determined only by supply and demand effect. Therefore there is no tangible or par value on which to base pricing - only the current price itself. This implies that a flat percentage margin rate is on shaky ground (just as a % of notional approach for OTC derivatives or futures is shaky ground).
- Design it: a bit of a "dark art" but a well versed quant should be able to rustle up a starter-for-10 hVaR method, stress method and a liquidity add-on method fairly rapidly
- Backtest it: play the margin results against a sample of FX portfolios to demonstrate exceedances are within the bounds of knowledge
- Commercialize it: either have each broker develop competitively or have a small number of vendors build and license their methods
- Build it: harness suitable IT staff or vendors.
- Approve it: regulators would want to approve and set minimums of a different kind e.g. confidence intervals, margin period of risk (MPOR) etc.