Four risk factors for the accumulation of risk in financial markets

Spark Global Limited reports:

Until everyone needs liquidity at the same time, it is hard to know how much leverage there is in the market.

Leverage can gather quietly in strange corners of the market, as the 2008 financial crisis and the recent collapse of Archaegos demonstrated.

I mean, who would have thought a bunch of media stocks like Viacom or Discovery would be at the forefront of a liquidity event?

Before we continue, let’s give a rough definition of leverage, because it means different things in the software world than it does in financial markets.

In this article, we will analyze the current level of leverage in the market through transparent data sources and try to estimate where the hidden leverage is.

The dangers of leverage
The dangers of leverage bring us back to the most basic practice in finance: lending. Banks lend, customers borrow.

Unsecured loans are based entirely on credit. If the borrower defaults, the bank is in trouble. Secured loans are loans backed by collateral, meaning that in the event of a default, banks have some assets tied to the loan that they can seize to cover some of the losses. That’s how mortgages work.

When conditions worsen, as they did in 2008, the value of customer collateral falls. So banks need more collateral so they don’t lose a lot of money if they default.

When banks demand more collateral from borrowers, they either default or raise cash in other ways.

They typically raise cash by selling other liquid assets. When everyone is selling liquid assets at the same time, it puts further downward pressure on prices across the industry, leading to a recession.

Borrowers have been hollowed out, either selling their assets at rock-bottom prices just to meet loan requirements, or they have defaulted on their loans and are now bankrupt. The banks lost a lot of money because a bunch of their loans went bad.

So you can see that if we toughen up the system, people borrow far more than they can afford, and banks lend, the negative feedback loop gets even worse.

There are many fascinating explanations for how the 2008 financial crisis happened, but at the most basic level it was about too much leverage in the financial system.

Today, we look back at the sources of dangerous and potentially hidden leverage in today’s financial system.

No, we do not cite 2008 to say that the financial system is in a similar situation today. Rather, we use it to illustrate the dangers of leverage.

First, we’ll review some publicly available data from the Financial Industry Regulatory Authority.

Margin debt is at an all-time high
One number we can transparently access is the total margin debt of finRA registered broker-dealers. FINRA is the self-regulatory body that regulates the security industry, and one of its responsibilities is to regulate registered broker-dealers.

These registered broker-dealers are required by FinRA to report certain data on their clients to ensure regulatory compliance, including the level of margin used by customers.

These data basically show us how much debt investors are getting into their brokers through margin debt. It answers the question: How much money do clients use that is not their own? That number has grown steadily since FINRA began collecting data in the late 1990s.

Below is our chart using a logarithmic scale of total debit balances on margin accounts for FINRA broker-dealer customers since 1997.

As you can see, the level of margin debt fluctuates with the market itself, but overall the number has been rising steadily and is now at an all-time high.