Margin debt has never been so high, and derivatives have surged, all of which has increased liquidity risk. Markets absolutely need to deleverage before any tapering, let alone tightening, can be considered.
At a time when markets are expecting the Fed to start tapering its asset purchases soon, it is interesting to look at how dependent on cheap money markets have become. In order to examine that, we need to have a look at margin debt, i.e. when you borrow money from your broker to buy and sell stocks. Margin accounts typically offer 2 to 1 leverage. If you put 100'000 $ into your margin account, you can buy 200'000 $ worth of stocks.
So how much borrowed money have investors used to bet on U.S. stocks? A good indicator is the margin debt figure for the New York Stock Exchange based on statistics from the FINRA. Margin debt has almost reached 900 billion $ in June of this year, according to this graph from advisorperspectives.com.
That is a record as a percentage of GDP and a record spike since February 2020. In particular, the use of intraday margin has greatly increased. Investing without any leverage in a market powered by asset purchases of $ 120 bn per month from the US central bank almost seems to look foolish. But the Archegos fund implosion in March 2021 was a reminder of the dangers of taking on excessive margin debt.
Historically, we’ve never been at such elevated levels. The graph shows that up until the turn of the century, the S&P 500 could go up with little margin debt involved, meaning that investors would more often use their own money while the margin debt turbocharge wasn’t as essential as it is today – particularly since 2009.
The June 2021 debt level is 4 to 5 times the 1997 level. The financial press has only focused on the latest drop in margin debt that occurred in July and is hardly visible on the chart above, and treated it as if it were a meaningful drop compared to the vertical surge we have had since March 2020. Financial news providers have seemed only interested in whether the drop in margin debt can be of any indication of future declines in the S&P 500. They have generally underplayed the role of margin debt as an advance indicator of index moves.
To make it short, the financial press loves it when margin debt rises and it only worries when it goes down, no matter how extreme the surge was in the previous months. But the crux of the matter lies completely elsewhere: in the amount of risk that margin debt has built into the market. Almost $ 900 bn in borrowed money at very cheap interest rates is a source of great fragility that is hardly compatible with tapering or rate-hiking. And this doesn’t even include the leverage created by derivative instruments.
Now, if we deduct from those $ 900 bn the cash accounts and credit balances on margin accounts, we are still left with a -450 bn $ credit balance for the NYSE accounts, the highest net exposure ever, as seen in the below graph from marketwatch.com :
The general argument is that margin debt, even ballooning as it is, should be seen as a positive. Unless markets decline, in which case it could make the decline much worse, as it amplifies downturns. The conditions, in short, for margin debt to be completely benign is for asset prices to keep rising and for the cost of borrowing to remain low. Who said any of this was guaranteed, and can this load of credit tolerate any change in monetary policy?
Let us now turn to another major source of risk and downward amplifier: the derivatives volumes which are several times leveraged, and have been ballooning as well. The latest data from the Bank for International Settlements (BIS) show a significant increase in the gross market value of over-the-counter (OTC) derivatives during the second half of 2020.
The fragility has also been building in the system because derivatives have exploded. Trading derivatives is the new trading. Interest rate derivatives in particular has become a big chunk of this universe. According to the BIS, the trading of interest rate derivatives in OTC markets more than doubled (+143%) between 2016 and 2019, fueled by low US short term interest rates, and significantly outpacing the growth of trading on exchanges. Even this OTC segment of the market is based on high margining and collateral requirements. This means that the counterparty risk and the collateral risk (the potential for the quality of the collateral to deteriorate) expose this huge $ 6500 bn market to changes in liquidity conditions.
Equity derivatives have also surged. «Equity-linked derivatives are increasingly popular with investors seeking exposure to U.S. equity markets», the BIS noted, with U.S. equity-linked derivatives now accounting for almost half of the market, up from less than a third in 2012. They have been shifting towards short-term instruments, making borrowing even more dependent on market rates.
During a giant bull market, risks tend to be forgotten and are no longer mentioned in the news or considerably understated even as they keep growing before our eyes. Before any interest rate hike is conceived, margin debt and derivatives leverage needs to considerably go down. So the first thing to do is for the market to trim back its own amount of leverage. Regulators could even step in to force an orderly withdrawal. This sounds unlikely. The question is: is this financial debt bubble reversible? If yes, monetary policy can be reversible. If not, monetary policy won’t be reversible either.