Margin trading plays a disproportionately large role in financial crises. What is it and how do we halt its impact?
The coronavirus (COVID-19) pandemic has brought the global stock market to its knees. In only a few short weeks, stocks have lost trillions of dollars in value, ending the longest-running bull market in history and triggering a global recession. In response, governments are scrambling to slash interest rates and introduce stimulus packages, but the question remains: what else can policymakers do to stabilise the markets? According to a new paper from Dr Bige Kahraman and Dr Heather Tookes, an important intervention connects to the root cause of financial contagions: margin trading.
The role of margin trading in financial epidemics
After the 2008 global financial crisis, academics and economists recognised that margin trading – the practice of using money borrowed from a lender to purchase stocks – can potentially play an outsized role in financial epidemics. To understand why, consider the following scenario: Imagine that a borrower wants to buy $10,000 worth of stock, but she only has $5,000 in cash on-hand. So, she borrows the other $5,000 from a lender. If the market is strong, this arrangement works well for both parties. But if the market experiences a downturn, one of two things tends to happen:
Firstly the lender might demand more collateral.If the lender loses confidence in the borrower’s ability to repay their loan, they may demand the borrower deposit additional funds to protect their investment. Or second the borrower hits margin constraints. If the borrower’s account falls below its minimum balance, they may be contractually obligated to post increased collateral or sell stock to repay the loan.
In either scenario, if the borrower does not have enough money on hand, she will have to sell other investments to raise the capital. If this same scenario plays out over and over again throughout the market, it’s not just risky stocks that will be sold. It’s safe ones, too. This leads to an increase in the propagation of initial shocks and the widespread of negative returns – also known as a financial contagion.
From anecdotal to empirical evidence
The scenarios described above are not controversial in academic or policy circles. However, finding empirical evidence to support the notion that margin trading impacts financial epidemics has proven difficult. That’s because regulators in Western markets do not typically allow access to margin trading data. This is where Kahraman and Tookes break new ground. As part of their study, they developed a first-of-its-kind partnership with India’s capital markets and received unprecedented access to individual lender and borrower data.
The data provided definitive answers to two long-standing questions: Is there evidence to support the claim that margin trading acts as an amplifier for the spread of negative stock returns during a market shock? And, if so, what exactly is its economic importance? What are underlying key drivers?
Yes, margin trading matters. A lot.
As outlined in their paper ‘Margin Trading and Comovement During Crises,’ Kahraman and Tookes find clear evidence that margin trading is a substantial contributor to the financial contagion effect. In fact, the authors note that ‘during crisis periods, return comovement doubles, and margin trading explains nearly 30% of this dramatic increase.’
The authors also discovered that lenders have a greater impact on margin-eligible stock performance in a crisis than borrowers do. Through the study, they were able to quantify the degree of amplification arising from lender versus borrower channels. They were able to identify the most important catalyst that sets these negative chains of events into motion: losses in lenders’ margin loan portfolios.
These are important breakthroughs, both for understanding the root causes of market contagions and for informing the design of successful interventions.
Lessons for policymakers
Taken together, the implications for policymakers are straightforward. To effectively stop the spread of financial contagion, governments should implement policies that recapitalise or subsidise lenders. Why? It’s not necessarily because lenders are more-or-less deserving of a bailout than borrowers or the public-at-large. It’s because if lenders are less concerned about the position of their loan portfolios, they are less likely to trigger a series of events that will result in a system-wide sell-off.
Margin Trading and Comovement During Crisis is written by Bige Kahraman and Heather Tookes, and is published in the Review of Finance.