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Originally, the principle of margin trading was associated with transactions in commodity markets. In XIX century, commodity exchanges were the markets, where payment for commercial transactions was made in cash. Intermediaries at these markets were brokers, who rendered services for execution of transactions, money transfer and maintenance of accounts. While maintaining accounts, brokers used a special accounting method, which was called 'circular'. This method allowed payments between clients in the most efficient way in case of repeated resale of goods.
The circular accounting method was used at futures markets until the 1920's, when it was able to satisfy the needs of futures markets. The method assumed that exchange members, when making transactions, fulfill their obligations as immediate participants of the agreement. They used to bear full responsibility for fulfillment of contract obligations. With such a settlement system the clients had an advantage that it was unnecessary to use own funds as a financial guarantee of fulfillment of a stock contract, and it cheapened stock trading for them.Earlier settlement procedures were more preferable for that stage of stock trading, when most of transactions were purely commodity-merchandise, i.e. purchases and sales were based on real needs for goods or goods themselves. Exchange members had to own considerable funds to guarantee fulfillment of their obligations in any case.
At modern stock exchanges a lot of speculative operations are carried out. In some economical situations, share of speculative operations increases dramatically, which may cause insolvency of clients and, consequently, of other exchange members. Growth of futures operations and increase of associated risks led to appearance of the clearing system for settlements of transactions, as well as a special division of the stock exchange - the clearing house (settlement house). Now every futures exchange or dealing center has a clearing mechanism, which ensures conclusion of all transactions in the market.
The basis of clearing settlements is a system of deposits or guarantee deposits, required from participants of futures operations. In exchange practice, such deposits are called a margin.
A futures contract does not suppose immediate delivery of goods and does not require complete payment of the transaction. Amount of money, which the client should pay to the account of a brokerage company or a dealing center when he opens his position, is called a margin (margin, original margin, necessary margin or initial margin). The margin rate is usually about 1-10% of the futures contract cost. Usually, if a contract is actively traded at the stock exchange, the pledge is small. If it is a contract for a rare asset, the pledge can amount to 100%.
Recently, due to increased liquidity of markets, especially of such markets as FOREX or Share CFD, the margin rate has dropped to 1% and virtually became a standard. This means that to buy a contract, for example, on the currency pair USD/JPY = 100,000 USD, the client should have at his account a sum equal to 1% of the transaction amount, i.e. 1,000 USD. Hence, in this case the necessary margin is equal to 1,000 USD. It provides the client with a lot of tempting possibilities, but also implies certain risks.
After opening of a position and depositing a margin, the contract cost is reevaluated every day. If one day changes in the situation in the futures market are favorable for the client, amount of money at the account increases by the amount of potential profit. If changes in price are unfavorable for the client, his initial margin is reduced.
All stock exchanges establish that as soon as the margin amount of the client reduces to a specified level, the broker should automatically close some or all positions of the client (Stop out). This system guarantees cover for potential losses of clients and receiving of profit by the brokerage company.
Due to the Internet boom and enhancement of software, cost of a contract, margin, floating profits or losses of the client are estimated practically every second. The client is enabled to carry out constant monitoring of his position and timely react to the situation, and the broker can indemnify himself from shifts and changes of the market by timely closing an insecure position.
The term 'margin' has multiple interpretations. Thus, in the securities market, the margin means money borrowed from brokerage company for purchase of securities. In the USA, the percentage of cash funds to be placed with the broker for purchase of securities is established by the Federal Reserve System and since 1974 is equal to 50% for common stocks. That is to say, the broker provides the client with leverage ratio 1:2. So, the investor can purchase securities for $20,000, depositing $10,000 and borrowing the rest from the broker. The loan is charge with interest, and securities serve as a guarantee.
In recent years, due to the investment boom and introduction of such an instrument as a CFD contract, leverage ratio 1:10 has become a common practice in CFD for common stocks, precious metals and other financial instruments.
The system of operation via a dealing (brokerage) company with provision of a credit leverage was called 'margin trading'. Margin trading is attractive due to its accessibility. High profitability of the securities market is attractive for investment in securities of the leading foreign countries. However, amount of dividends directly depends on successful performance of a concrete enterprise and preferences of its stockholders. It is more interesting to buy stock in order to speculate for their rise, but it requires considerable investments. Margin trading does not have the described limitation. You can sell and buy financial assets, depending on your expectations. Margin trading allows experienced participants in financial markets to maximize efficiency of transactions in the securities market.
However, it should be remembered that the leverage linearly increases any financial result, both positive and negative. By opening a position with leverage, the client increases his market risk proportionally to the leverage amount and can lose all his capital because of an adverse market conditions. Thus, uncontrollable losses from clients' positions may cause solvency crises of participants and lead to the market collapse.
To illustrate such a situation, we will give an example of the biggest financial swindle, based on the margin trading principle.
In February of 1995 one of the oldest English banks, Barings, collapsed, because it was unable to secure immense liabilities, made by the young trader Nick Lisson during speculation deals with the Japanese stock index Nikkei in Singapore.
Nick Lisson played with the increasing Japanese stock index without guarantee, which was the reason of collapse of Barings. The remarkable fact is that according to the Barings' forecast the Japanese stock market was estimated as a 'bull market', that is to say very optimistically, and Japanese expert were very surprised with this. Such forecast obviously contradicted political problems in the country and a recent earthquake. But Nick Lisson underestimated the situation and kept on acting very incautiously, going so far in his speculations that he just could not find a way out without wide publicity. He continued gambling. In the long run, the branch of Barings in Singapore accumulated financial liabilities for $29,000,000,000. However, Lisson continued placing his stakes on rise of stocks and tried to achieve positive results by mass purchasing of index futures, secretly from the bank management.
According to the bank management, volume of transactions became known only on February 24, on the next day after Lisson's disappearance. On February 17, Barings authorized preliminary investigation of Lisson's transactions in Singapore, but it was too late.
Development of margin trading became very popular for operations at FOREX. In many countries medium and small investors have an access to the world currency market, using in their transactions sums up to $10,000, through the margin trading system and using of leverage.
A dealing company provides to its clients a credit, which is several times more that the deposit. Amount of guarantee (margin) is established by the bank of dealing company, where the client's deposit is placed. The mechanism is quite simple. In order to by a lot, standard for the currency market (100,000 EUR) at the price 1.23 EUR/USD, it is required to have for the guarantee only 1,230 EUR.
Amount of the marginal position of an average speculator is comparable with a position of a quite big investor. Although it is difficult to estimate the share of leverage transactions in the total turnover, it is obvious that their influence on the market conditions is very significant.
Working in high-risk markets requires that the risk management system enables automatic tracking of all positions of clients and exclusion of losses higher than their own funds. Establishment of the system, performing online tracking all positions of clients, which can reach tens of thousand with big operators, is a very complicated task. Its solution requires high professionalism, information technologies, software and financing.
It is obvious that today not any, even big, company has sufficient capital, depository and settlement system, developed technologies and effective risk management at the same time. Meanwhile, the absence of just one of the listed parameters makes transaction much riskier both for clients and brokers.
Investment banks, because of initially more severe requirements, have better starting positions for leverage transactions. As for small companies, their flexibility, which is often lacked by their bigger competitors, allows them keeping a niche in the brokerage market.
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