5 Regulation and operation of the exchanges
5.6 Cash and margin accounts
This is not a problem in France, Italy, Spain and Greece where such deals have up to now been forbidden. To allay concerns in Mediterranean states with less developed financial markets, that investors who trade off-exchange might be vulnerable to being ripped off, the European Commission is proposing that there should be pre-trade transparency:
Investment banks would have to make firm quotes public ahead of a trade,9and This requirement will only be lifted for transactions above a certain size, as parties to it could be assumed to be sufficiently knowledgeable.
This EU proposal is not liked by investment banks, which protest that it constitutes too great a regulatory burden. In their opinion, the obligation to honor pre-trade prices runs counter to the need to adapt to market circumstances. Contrarians think that the big banks’ reaction is not based on a strong argument, because, no matter which may be the specific regulatory regime for fair trading purposes, a facility must be provided that records up-to-the-minute information for investors on price and volume of all big-block transactions in a given equity or other commodity,
Whether these trades are on an exchange or in the third market, and Whether they concern purchases or sales of large blocks of securities.
Moreover, if corporate insiders are buying or selling equity, then this company’s shareholders have the right to know immediately how their management teams are exercising the power vested in them by their stakeholders. Big-block trading can dearly affect a company’s capitalization and, in a way, its fortunes. They can also be a covert way to bypass regulations, as well as to provide a basis for switches in ownership of an entity which may be against its shareholders’ interests.
not specify the amount of the loan, the broker obtains a demand or call loan from his or her own bank,
This loan is renewed daily, and
It is secured by collateral consisting of diversified stocks and bonds carried for the customers who are on margin.
The margin required of the broker by the bank must be distinguished from the margin required by the broker of his customers. A similar statement is valid regarding the initial margin at the time the stock is bought, from that subsequently maintained.
In the USA the Securities Exchange Act of 1934 empowered the Federal Reserve to set initial margins on registered securities, while the stock exchange fixes minimum margins that must be maintained in the account.
The Fed authorities also regulate margins on loans to brokers and dealers, except when secured by customers’ collateral. With such facilities in place, stockbrokers inform their customers that they can lawfully borrow funds to purchase securities.
The broker’s collateral for the loan will be the securities purchased, other assets the customer has in his or her margin account and other assets in any other accounts at the broker.
If the securities in an investor’s margin account decline in value, so does the value of the collateral supporting the loans,
Then, the broker is empowered to take action, such as issue a margin call and/or sell securities or other assets in any of the client’s accounts held.
This is reasonable enough, since the broker has to maintain the required balance of risk in each of his or her customers’ accounts. What is important, however, but is not self-evident, is that the customer fully understands the exposure involved in trading securities on margin. Such exposure includes a number of issues summarized in the following list:
The client can lose more funds than he or she deposits in the margin account.
The broker can force the sale of securities or other assets in the investor’s account(s) without contacting him or her.
The investor is not entitled to choose which securities, or other assets, in his or her account(s) are liquidated or sold to meet a margin call.
The broker can increase his or herhousemaintenance margin requirements at any time, and is not required to provide advance written notice to the client.
The client isnotentitled to an extension of time on a margin call, even if he or she asks for one because he or she faces financial problems.
As can be seen from this list, no matter if margin accounts are legal under the 1934 Act, they are a danger to the investor’s assets. Beyond what these five items have indicated, margin accounts give the broker not only the right to borrow cash from the customer’s cash account, but also to borrow stock from it. This is implicit in the signing of a margin agreement by the customer.
As a result of outstanding and not cancelled margin agreements, when they receive their statement many investors find that their account was switched from a cash to a margin account as a routine course without their knowledge or consent. For instance, if there has been a small debit balance in a customer’s cash account, instead of requesting payment, the broker:
Can use the opportunity to lend this customer money, and Then switch to margin the customer’s account.
This permits the broker to kill two birds with one well-placed stone, given the advan- tages margin accounts provide to brokers. Neither is it an unusual practice that sales people are offered a bonus for opening margin accounts, allowing the broker to borrow any securities which he or she may be carrying for the customer to securities ‘loaned’
to the broker or dealer. These will be used by the broker or dealer as part of his or her capital, subject to the risks of the business the broker or dealer takes.
The freedom to use the customers’ securities as his or her own, has often led to the curious phenomenon known as failure to deliver by brokerage firms. For instance, when the margin customer sells stock, this has already been sold by a short seller, who has borrowed such security from the broker, and the broker does not have the equity to deliver to the buyer. Investors should therefore always remember the second golden rule: ‘Do not borrow, do not buy on margin, do not leverage yourself and do not sell short.’ Always remember that:
Fully paid investors’ securities cannot be legally sold by the broker,
But those that were in margin accounts can be pledged and handled as the broker wishes.
Once a customer signs a margin agreement, whether or not he or she makes use of it, he or she consents to the use of the cash and equities. Beyond this, the customer leaves his or her securities with the broker in street name, and the broker uses them the way that best fits his or her business interests – from lending them to hedge funds and speculators, to voting as he or she chooses on the owner’s behalf.
It is appropriate to note in this connection that the restrictions imposed for paid securities on brokers and exchanges are valid under US law because of the 1934 Act.
They are not necessarily representative of European, Asian or Latin American juris- dictions. Every state has its own laws, and investors will be well advised to study these lawsbeforeopening an account with a local broker.
The reader would also want to take note of another fact. A portfolio of equities can and often has been used as collateral. The problem, however, is that equities are too volatile for this role, and using them as collateral makes them even more volatile.
This is true in the general case, not only in connection with accounts with brokers and dealers.
When a bank makes a non-purpose loan and the collateral used is stock, the stock is put in the bank’s custody. That is the way the system works. Although, technically, banks are obliged to contact their borrower before they sell his or her stock, they often sell it without notice when the price falls below a certain level – in exactly the same way as described in the preceding paragraphs in connection with margin accounts.
This is not totally unreasonable because banks have to protect themselves. To do so, they often enter stop orders in the specialist’s book if they think the market might drop. Such practice is even more common amongunregulated lenders, that is, lenders other than banks and brokers, who take stocks as collateral but are not subject to Federal Reserve controls.
Since they lend a high percentage of equities left with them as collateral, and they have as a result less of a cushion than regulated lenders, entities working as unreg- ulated lenders tend frequently to enter stop orders. There is also another important difference:
With regulated lenders, the amount of collateral must be a specified percentage of money borrowed.
By contrast, unregulated lenders decide for themselves what percentage of the loan they want as collateral.
In conclusion, non-purpose loans principally used as collateral for stocks which could be carried at loan margin are easily subject to an unfavorable sale of the collateral by custodians during deteriorating markets conditions. This constitutes a potential threat to the borrower’s wealth but also to market stability, as the fact that price volatility causes the lender to sell out the collateral if the maintenance limit is passed when prices decline, leads to a vicious cycle.